Book Review: Pragmatic Capitalism

Pragmatic Capitalism: What Every Investor Needs to Know About Money and Finance

• Cullen Roche
• The book can be found here.
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Book Overview

While Ben Graham was the consummate “bottoms up” investor, it could said that Cullen Roche is the consummate “top down” investor. For several years, Roche has managed the blog, Pragmatic Capitalism, which has been a great resource for us for getting fresh macroeconomic ideas and perspectives in a rapidly evolving world.

Now Roche has synthesized his sophisticated macro views into a book, “Pragmatic Capitalism: What Every Investor Needs to Know About Money and Finance,” (a copy is available here).

This book is not so much an explicit “how to” investing or asset allocation cookbook, but is more of a broad framework for thinking about portfolio construction, and how to apply a macreconomic perspective to the investing and asset allocation process. Roche’s deep understanding of economics and finance shines through as he elucidates his own macro philosophy, and how readers can apply a similar macro perspective to thinking about their own portfolios.

What I like about the book?

Pragmatic Capitalism progresses towards a thorough discussion of economics, by building his case piecemeal.

Roche starts by laying out some basic building blocks, including an overview of the concept of money, and remarks on money as a social construct, and a medium of exchange, as well as the notion of fiat money; he also alludes to how most modern money is credit (which sets the stage for a discussion of the monetary system later in the book).

Next, shifting to economics, he discusses how in an increasingly integrated global economy, it is important to maintain a “big picture” perspective, versus a more “local” perspective that prevailed in the time of Ben Graham, when investors focused on bottoms up analysis of individual companies. The modern world is obviously very different from the days when the Intelligent Investor was published, as today S&P companies generate an ever growing portion of their earnings abroad, and market correlations increase. Between 1990 and 1995, US markets had a 29% correlation with global markets, whereas between 2005 and 2010 the correlation was 73%. That’s a big change. Although many of us are conditioned to think locally, the spread of technology, rapid growth of an emerging global middle class, and the integration of markets demand that we think globally.

Moving to a personal perspective, Roche counsels us to make a distinction between investing and saving. The semantics here are subtle. Roche defines “investing” as it relates to capital investments that are then used generate production or productivity in the future. Investing might include financing your own entrepreneurial business that will use the money to finance future growth, or an investment in your own education, or job training, which might enhance your career prospects. Investing can be for “hitting a home run.” Saving, by contrast, is allocating capital that is neither consumed nor invested, but that you might consume (or invest) in the future. We should be more careful with this capital, since we may have a real need for it at some point, as with a specific event like college tuition, or an emergency. With savings, we are focused on preserving purchasing power and protecting ourselves from a permanent loss of capital. Roche returns to this concept later.

Next, Roche discusses a number of market myths which, though untrue, we persist in believing, and which cause us to do things we shouldn’t do. Many of these are solid contributions. You’re not going to be Warren Buffett, and trying to beat the market causes problems. The stock market won’t make you rich, and neither will anticipating the “next big thing.” High fees don’t always equate with good value. Modern portfolio theory does a poor job explaining how to construct the portfolio. There are other good observations that can help investors avoid common pitfalls in managing their finances.

The next section was my favorite part of the book, and covers how the new macroeconomy is changing portfolio construction. This relates to the “savings” portfolio, as defined earlier, which allocates capital that you may need to access at some point in the future.

Roche divides global assets into 7 classes on a spectrum, with protection against loss of purchasing power at the top and protection against permanent loss at the bottom:

1. Emerging market equities and developed market small cap equities
2. Developed market large cap equities
3. High yield corporate bonds, preferred stock and REITs
4. Foreign emerging market corporate bonds, foreign emerging market government debt
5. Investment grade corporate bonds, municipal bonds
6. TIPs, long-term developed market government bonds, intermediate term developed market government bonds
7. Money market funds, treasury bills, bank deposits, cash

Roche views risk as the “potential you will not meet your financial goals.” This spectrum is useful for thinking about allocating across these asset classes, based on whether you are generally accumulating or protecting assets.

When you’re younger, gathering assets, and with a longer investing horizon, you might emphasize protecting against the loss of purchasing power, while when you’re older you might focus more on capital preservation. There’s no radical new thinking here, but by thinking broadly in terms of matching assets (savings) and liabilities (future needs) instead of using some whiz-bang mean-variance approach, you can position yourself with a more individualized and practical approach that will maximize your chances for meeting your financial goals. Roche also advises us to establish a methodology, automate it, and stick to it. This is good common sense advice that can be easy to forget in a rapidly changing world.

Next Roche tackles the importance of an appreciation of behavioral finance, and how our behavioral instincts affect financial markets and can lead us astray. This section includes a nice overview of a number of well-known behavioral biases, and how they make us behave irrationally. But there’s good news: if we can accept and acknowledge our biases and weaknesses, we can learn to identify and avoid them.

Roche then takes us through the workings of the modern monetary system. This section was dense, but enjoyable. Roche builds on his earlier discussion of money, by discussing private sector banking, the public sector and central banks, and currencies.

He discusses the flexibility of our money supply, and the role of Inside Money (deposits) and Outside Money (reserves). Roche includes a good overview and uses clear and plain language:

“…deposits are the money most economic agents use to transact with one another, while reserves are the money banks use to transact with one another.”

Concise statements like this served as a useful clarifying guides for me as I moved through the book. I especially enjoyed Roche’s intuitive explanation of how the instability of Inside Money (chiefly private sector bank deposits) can be offset with changes in Outside Money (chiefly cash and bank reserves). There’s a nice intuitive simplicity to that view. There’s also an overview of inflation and deflation, fractional reserve lending, shadow banking, the credit cycle, monetary and fiscal policy, and central bank policy.

Given this background, Roche then moves to address a number of economic and monetary myths that persist. These include many seen in the financial press and finance blogs today: the U.S. is going bankrupt, quantitative easing will cause hyperinflation, markets are perfect and can solve all our problems, economists have all the answers. This section was lively and provocative, and demonstrated Roche’s deep and comprehensive understanding of economics.

Finally, he summarizes his macroeconomic views, and how we can all exercise more pragmatic capitalism. We can do so by focusing on the “big picture,” being mindful of the globalization of economies and markets, by distinguishing between our investing and saving, by allocating savings across asset classes consistent with our personal goals, by avoiding our behavioral biases, and by understanding the true nature of money, the monetary system, and economics. This integrated view will provide you with a perspective that will prepare you to be an effective, and informed investor and an engaged participant in today’s economic world.

Wrapping up, Roche includes a fantastic “Suggested Reading” list. If you are looking to broaden your knowledge of economics, finance and investing, this a great list to consult.

Constructive Criticism

I thought Roche’s distinction between investing and savings was confusing, and it was a fairly significant theme of the book. I felt like Roche devoted too much time to this, and it added an unnecessary layer of complexity to an otherwise clear economic philosophy. For instance, what he calls “savings” is what most people call investing. Furthermore, what if you “invest” (by his definition) in your own business, with the proceeds to be used by the business to grow, but later you sell your business? Is investment then translated into savings? Many would describe Roche’s “investing” as a private equity investing, and by doing so you could simply view it as another asset class, and place it along the purchasing power/preservation spectrum.

Also, I didn’t like how his asset allocation methodology provided merely a framework for thinking about how to allocate, when I was looking for more specifics. If you wanted to use this book to inform your portfolio construction, there would be a lot of judgment involved. Sure, if I were on the cusp of retirement, I would understand how I might prefer more bonds as protection against permanent capital impairment, and less emerging market equity. But how much of each? There were some broad equity/bond splits referenced, but Roche does not provide much in the way of tools, or even any rules of thumb, that would allow a more granular view on how to allocate based on circumstances.

I thought Roche tried to tackle too much in his overview of the modern monetary system. If you haven’t spent a lot of time thinking about these issues, you might consider this section to be too technical, with too many loose ends, and leaving too many questions unanswered. There are shelves of books written on the Fed, inflation, fiscal policy, etc. Trying to encapsulate these and many other complex ideas for the layman in a mere 51 pages is a tall order, although to his credit as an economist, Roche does an admirable job.

Roche can also be quick to dismiss certain macroeconomic views. For instance, he includes a one-page takedown of the IS-LM model I learned from Andrew Abel at Wharton from his textbook, “Macroeconomics,” which Abel co-wrote with none other than Ben Bernanke. We all know aspects of modern economics are not perfect, but these can still be useful tools that yield valuable insights. I’m not sure I’m prepared to completely ignore this branch of economics based on a few paragraphs from Roche that reject it.

Summary:

Nevertheless, for a short book that covers an extremely broad subject area, Pragmatic Capitalism does an excellent job overall. While not geared for beginner economists, it offers a clear discussion of sophisticated economic issues that will be informative for those who have some exposure to the field. If you are prepared to move quickly through many subject areas, I think you will enjoy the book and undoubtedly broaden your knowledge base. In particular, Roche’s framework for understanding the integration of economies, and how, within that context, to build a portfolio consistent with your own financial goals is a definite practical benefit available to anyone who takes the time to understand Roche’s nuanced viewpoint.

In the end, we could all benefit from being more pragmatic capitalists.