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To Get Smarter Financially, It Helps To Think In Extremes

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To Get Smarter Financially, It Helps To Think In Extremes

If you want to get smarter financially, it helps to think in extremes. Thinking in extremes makes financial concepts easier to understand.

Since 2009, I’ve been using my background in finance to help readers and listeners achieve financial freedom sooner. However, before I graduated from business school in 2006, my confidence in understanding financial concepts was tenuous. I was an economics major who thought about macroeconomic and microeconomic events.

Finance, economics, and investing can be intimidating. As a result, many people don’t bother to learn them. Some even think finance is the language of the elite, which it is not. If a public school kid who got a mediocre SAT score can understand finance, so can you.

Out Of Consensus Call On Interest Rates

Because I enjoy reading and writing about economics and finance, the Twitter algorithm shows me related posts. Below is a post by Jim Bianco, a veteran financial research strategist who started his own firm 25 years ago. Jim is about 57 years old and I respect his viewpoints.

Jim goes on to write, “Yes, the Cleveland Fed has overstated CPI in recent months. But it has been by 0.1% or 0.2%. So, even factoring in an overstate again, August and September CPI are looking at relatively large numbers unless you want to make the case that they will massively overstate now, I cannot.

YoY CPI bottomed at 3.0% in June. If YoY CPI is pushing 4.0% by September (reported in mid-October), I cannot see how the Fed pauses from raising rates, and any 2024 rate cut is out of the question.”

I appreciate Jim’s point of view because it is not part of the majority. The majority of economists, strategists, and researchers believe the Fed is done hiking rates for 2023, and will cut sometime in 2024.

To be specific, only about 10%, 28%, 20% of traders believe the Fed will hike rates in September, November, or December, respectively. So if you were a betting person, you would bet on no rate hikes in 2023.

Think In Extremes To Improve Critical Thinking

For anybody who drives, it’s evident that gasoline prices have rebounded since the summer. Therefore, given gasoline prices are part of CPI, it shouldn’t be a surprise if September CPI ticks up, when reported in October.

However, is it logical to assume the rise in gasoline prices will spur the Fed to hike rates more in 2023 and not cut in 2024? I’m not so sure.

This is where thinking in extremes can provide some financial clarity.

WTI prices from 2021 to 2023, going up in 2023

What If Gasoline Prices Went To $20/Gallon?

Let’s say gasoline prices rise from $5/gallon to $20/gallon, an extreme move. It now costs $264 to fill up your empty Toyota Corolla tank. If you have a Range Rover Sport, it will now cost $492 to fill up your tank. Holy crap!

Given a large portion of the population can’t live without a car for work or school, there will be a large reduction in disposable income. Of course a lot of people will switch to public transportation, car pooling, walking, biking, and scootering. But some will simply have to take the pain of rising gasoline costs.

With a significant consumption slowdown due to higher gasoline prices, is the Fed more inclined to raise rates or lower rates? Consumption (C) is the largest component of GDP. If gasoline prices stay at these elevated levels for months, another recession is all but inevitable.

But maybe what Jim is saying is that higher gasoline prices are due to strengthening demand. Although what’s also plausible are production cuts by Saudi Arabia and OPEC and extreme heat shutting down supply as the main drivers of higher gas prices. See chart below.

Oil supply squeeze, less supply boosts oil and gas prices

Rising Gasoline Prices Help Do The Fed’s Job

The Fed has been hiking rates aggressively since 2022 to try and tame inflation. The higher borrowing costs go, the less people borrow and buy things they don’t need.

Higher interest rates also crowd out private investment spending, given investors can now earn higher risk-free rates of return in money market funds, CDs, and Treasury bonds.

Higher gasoline prices are also a tax on the average consumer. But in this case, many people have no choice but to pay the higher gasoline prices.

With higher interest rates, on the other hand, not everybody will feel the same brunt. After all, roughly 40% of American homeowners don’t have mortgages. And nobody is forcing anybody to take out debt to buy something they don’t need.

In fact, for savers and investors, high interest rates are great! But unless you buy oil stocks or own oil fields, it’s harder to benefit from higher gasoline prices.

Higher gasoline prices help the Fed do its job of slowing down the economy. Therefore, higher gasoline prices would be more of a reason to keep rates steady or even cut rates, not hike rates.

The Fed Could Still Hike Rates

Of course, the Fed could still hike the Fed Funds rate by the end of 2023 for a plethora of reasons. However, I don’t think rising gasoline prices would be one of them.

More logical reasons would include a continued robust labor market, a re-acceleration in rents and home price appreciation, greater-than-expected increase in borrowing demand, and a return of speculative frenzy in the stock market.

12-month CPI rose to 3.7% in August from 3.2% in July.

12-month CPI rose to 3.7% in August from 3.2% in July, largely driven by gas prices up 0.6% in August.

Why You Need To Understand Finance

At the end of the day, the reason why you want to get smarter financially is so that you can make more optimal financial decisions based on your goals and risk tolerance. The more you can understand, the more you can prepare your finances for potential surprises.

For me, if the Fed does hike again in 2023, then I will be prepared for a potential sell-off in the stock market as a hike is currently not expected. I’ll probably do some buying if the sell-off gets bad enough, which is one of the reasons why I have dry powder.

If the Fed keeps the Fed Funds rate the same all of 2024, then I’ll likely invest more of my free cash flow into Treasuries and relax. Earning ~5.5% risk-free is wonderful given the income can pay for more than double our living expenses.

It’s hard to be a great investor. But I say you don’t have to be one to build great wealth. All you’ve got to be is a good-enough investor who asset allocates appropriately over the long term.

The more you can understand finance, the more confident you will feel about your money. The ebbs and flows of the world will also be easier to handle. Having a strong mind is one of the best sources of financial security.

Other Examples Of Thinking In Extremes To Help Better Understand

Maybe you’re not convinced by my gasoline prices going to $20/gallon example. Here are three more examples of how thinking in extremes help you learn.

Example #1: Housing Contract

You don’t understand why buying a home with contingencies is like getting a free call option. Think in extremes.

Instead of having a 30-day contingency, imagine having a 20-year contingency. In 20 years, you have the option to buy the house at today’s contract purchase price if everything checks out. Therefore, having this option is worth a lot! As such, your goal as a buyer is to have as long of a contingency as possible.

Example #2: Bond Prices

You don’t understand why bond prices go down when interest rates and inflation go up and vice versa.

Let’s say a one-year bond costs $100 and pays a $3 annual coupon (3% yield) in a 2% inflation environment. How much would you pay for the $100 bond if inflation goes up to 100% a year? Probably no more than $50, or down 50%.

Even if you get all your money back ($100) in a year plus $3, due to 100% inflation, your $103 is worth only about $51.50 in real terms (can only buy $51.50 worth of stuff versus $103 last year).

In a 100% inflationary environment, there will be new bonds issued with a 100%+ yield to attract enough demand. Therefore, your 3%-yielding coupon is worth much less.

Example #3: Looking For Love

A girl rejects you and you don’t know why. You’re fit, good looking, and kind.

Your current occupation is unemployed after a five-year run at a big tech company. As a computer engineer, you’re confident you’ll find another job soon. She, not so much.

The girl is afraid you will end up living at home with your parents. After five years, you might spiral down a dark hole of despair because you still haven’t found a job or purpose.

She doesn’t want to risk getting dragged down in your misery because she grew up in a poor single-parent household. Her father was also once kind, but turned violent after the money disappeared.

Hence, by thinking in extremes, your solution is to move on or try again once you have a stable job.

Also Think In Probabilities

The more you can think in extremes, the easier it is to understand why things are the way they are.

Complimentary to thinking in extremes is thinking in probabilities, as I write in my bestseller, Buy This Not That. The more you can extend your thinking while mixing in probability analysis, the better critical thinker you will become.

Thinking in probabilities helps you accept your chances of being wrong and mute its impact if you are. Conversely, thinking in absolutes will make each error feel more devastating because you didn’t prepare appropriately.

Finance, investing, and economics are complicated subjects. But over time you’ll get more comfortable understanding everything you read by thinking in extremes and probabilities.

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