On Wall Street there is a term for the average investor, the non-institutional muppet that fuels the market for institutional gain. These are the people that buy at the market high and then sell when panic sets in and things become oversold. They jump from latest fad to latest fad based on a stock tip they heard on CNBC. Or from their neighbor who talked to a friend who knows someone who works at.... Almost all of us have been one, but we'll never admit it. This type of investor is what is known as "dumb money".

I finished my undergraduate work in 1995 and, at that point in time and for the next few years, the dumb money was in tech stocks. The feeling that you couldn't lose in tech stocks ensured that, ultimately, almost all the dumb money lost. I was no different. In 1999 I bought Yahoo! -- my personal favorite tech company at the time -- for around $210 per share. It fell to single digits and today trades at $23.50. I thought I knew what I was doing, but the reality was I knew just enough to get suckered.

The next market for dumb money was in housing. Housing prices that climbed 10, 20 or 30%+ each year created a market ripe for attracting dumb money. Something should have tipped us all off when it was cheaper to buy new than to rent -- a mathematical absurdity that persists to this day in some pockets -- but millions would not be deterred. If you want a great book to understand the mentality of dumb money, I highly recommend Michael Lewis' The Big Short.

In many respects, local governments have long been dumb money and are now trying to fill the dumb money void in a big way. In the pursuit of growth, local governments have seemed to reach new levels of delusion as the housing crisis has persisted, real growth has stagnated, the traditional mechanisms of post WW II growth have waned and we've gone further into the Desperation Phase of the Suburban Experiment. In the last few years we have seen local governments throwing money into all kinds of schemes, from extending infrastructure in a down market to giving tax breaks to anyone that asks to outright paying people to build homes. None of this has ever been put through a financial analysis. It's just dumb money.

If our cities want to avoid insolvency and financial collapse (see Detroit), they will get out of the dumb money business. Now.

Last week I established three basic rules for cities to use when making capital investments. 

  1. Will it generate a REAL rate of return?
  2. Will that rate of return be capturable in amounts sufficient to actually fund the project?
  3. Is the revenue stream capable of sustaining the improvement over multiple life cycles?

Where we can answer affirmatively to these three rules, the project has essentially no -- or at least very low -- risk for the local unit of government. Where we can't answer these questions, we have a project that amounts to speculation. Gambling, if you will. 

Let me be clear right now: gambling is an important part of a local government's growth portfolio. In fact, gambling is an essential strategy for investing for a strong town.

The optimum portfolio for local governments is simple to understand. It blends projects that have no risk with projects that have high risk in a combination that provides for great upside with very limited downside exposure. Here is how it works.

In any given year, a city should spend a high percentage of their capital improvement dollars on projects that meet the three rules for capital investments. If the projected rate of return for those projects is 5%, then the local government should spend 95% of their improvement budget on them. (95.24% to be precise, which is 1/1.05). This would mean that, by spending 95% of the budget and getting a 5% return, we can get 100% of our money back each year. No taxpayer money will be lost and, thus, the city's downside risk is limited.

After doing this, the city still has 5% (actually, 4.76%) of the budget remaining. This is the "gambling" money. This is the money that should be spent on the things that we think might work but we really don't know. This is the high, high risk part of the portfolio. If it is all lost, well then we can go back to the adage "nothing ventured, nothing gained". The city is still solvent and we try a better mix next year. If we have a winner, then we've made a gain while venturing only our extra money. This is how you capture upside risk in the portfolio.

From a mentality standpoint, what this does is shift our cities from being the dumb money where, upon the advice of an expert class, we take moderate risks everywhere -- never venturing anything truly dramatic but never really secure that things will actually work -- to being smart money with a mindset that is 95% stodgy accountant and 5% venture capitalist.

Let me put some numbers to this. For every million dollars spent a year on capital investments, 95% of that should be in projects that have a guaranteed 5% rate of return. The remaining 5% should be used on risky projects, experiments that may or may not actually add value to the community.  

For a 5% return on investment environment

$1,000,000 budget

$ 950,000 from budget spent on guaranteed projects

$  50,000 returned from investment

$  50,000 from budget spent on experimental projects

For a 8% return on investment environment

$1,000,000 budget

$ 920,000 from budget spent on guaranteed projects

$  80,000 returned from investment

$  80,000 from budget spent on experimental projects

(Note again that this is not precise math for all you math geeks, but precise math would only complicate the point. Let's get the point and then we can go out to two decimal places.)

I know this creates a number of questions for people: What does a guaranteed project look like? What does an experimental project look like? Most of our capital money is spent on maintenance so how does this apply? This is nice in theory but how how do we move from what we currently are doing to this approach? What is the role of professionals in this type of approach?

I'm going to spend the next few weeks delving into these questions. For the time being, you can think of a guaranteed project as one that looks a lot like the traditional development pattern (the pre-World War II pattern of development). That was the way these places we built prior to the automobile, Keynesianism and a centralized eocnomy. Local government was not a tool of speculation but a collective organization that, to one extent or another, cared for the commons in a very risk-adverse manner. Large scale speculation was done in the private sector, which meant it was generally not done or done in small, scalable increments. 

In comparison, an experimental project looks a lot like today's Tactical Urbanism; small interventions to identify overlooked opportunities. I'll talk about this in more depth in the coming weeks, but needless to say, all of you out there scoffing at Tactical Urbanism as a waste of time while simultaneously believing that venture capital is an important market shaper are not grasping either concept fully.

And finally, I know there is a group of you out there that repels at the notion of reducing government to dollars and cents. You are altruistic about the role of government and believe that, when properly run by the right people making the right decisions, it can be a force for good in this world. I'm not going to waste time debating the merits of this belief, but will simply point out this hard truth:

If a local government doesn't do projects that generate a REAL rate of return and creates capturable revenue streams to cover the government's short and long-term costs, then that local government will ultimately be insolvent. An insolvent government hurts people and creates painful instability, as does one trending towards insolvency. Any altruistic values of local government are compromised once the public balance sheet is inverted.

We all have an interest in building strong towns.

 

If you'd like more from Chuck Marohn, you should really get a copy of his recent book, Thoughts on Building Strong Towns (Volume 1). It is a primer on the Strong Towns movement and an essential read for those wanting to get up to speed quickly.

You can also chat with Chuck, Nate Hood, Andrew Burleson, Justin Burslie and many others over at the Strong Towns Network. Join the conversation on how to make yours a strong town.