Money and Investing
What is money?
Money is a convenient store of energy. You expend energy today at your job, and your employer pays you in money. If she paid you in wheat, you would have too much wheat, and no toilet paper. So she pays you in dollars (or yen). The farmer accepts a similar unit of storage in exchange for his energy in producing wheat. Middle men get paid in money for their energy in moving the wheat from the farmer to you. Maybe they had to store it. Maybe they changed it in form to bread or pasta. Every addition of energy has a value (hopefully) which is represented by the price paid for it.
Now money has some very valuable characteristics. It is easy to store. It does not spoil (ignoring inflation for a moment). It has a constant, generally agreed upon value (ignoring currency markets for a moment). You can transfer it to others easily. You can measure it. There are no practical limits to how much can be accumulated. Imagine if you had to pay for an automobile (or a snickers bar) in wheat. Imagine if Bill Gates wanted to store his wealth entirely in wheat!!
What is investing?
Investing in all of its various forms is simply an attempt to utilize stored energy to collect or create more energy. Consumption is the use of energy. You buy a car (or a snickers bar) and you are consuming energy. If you buy a truck that helps you earn money, it is helping you to collect energy. This is an investment. A machine that allows a farmer to harvest more wheat in a day is also an investment. If you buy a snickers bar and sell it to someone at a profit, this is also an investment. Therefore the difference between investment and consumption is one of intent and use.
Some people try to define a difference between investing and speculating. They are different only in their method and possibly in their risk profile. But speculators and investors both use their capital (stored energy) to earn a return on their investment (collect more stored energy).
Successful investing is harder to define. At the simplest level, if you end up with more energy than you started with, then your investment was a success. However, you have three opponents who will try to keep you from your goal. They are known as inflation, taxes, and currency exchange rates, *the three horseman of investing”.
Inflation is like rotting wheat stored in the barn. Every minute you leave it there, you have less and less wheat, and if you leave it long enough it will be gone. When money suffers from inflation, you can convert it into more energy today than you can tomorrow. With an inflating currency, if you do not earn at least enough to replace what is rotting away, then you will have less than you started with, and therefore an unsuccessful investment.
Just as wheat becomes less valuable in times of good harvests, money becomes less valuable as more of it is available. When excess amounts of money build up, people are inclined to spend money more freely. This can cause gradually increasing prices, and inflation. Note that the excess money itself does not cause inflation, but the gradual willingness of people to spend more and get less. Other factors can also influence this willingness to spend, mostly revolving around future expectations. War can cause inflation, as people anticipate shortages and bid up prices for existing goods. The expectation of inflation can itself cause inflation, with no other outside stimuli. This was a major factor in the 1970′s and 1980′s hyperinflation experienced by many countries.
Of course, dramatic changes in the supply/demand balance for one or many items can cause inflation as well. One of the best investments of the early 1990′s was freon. As government regulations required producers to stop making it, existing supplies grew in value by a factor of 50 or 100. A forward thinking auto mechanic with a warehouse could have made a fortune. One area worth watching is what happens to world energy prices as China and India begin consuming more energy for industry, transportation, and personal use. Even a small per capita increase will have a huge impact on demand, due to the size of their populations.
Taxes work in conjunction with inflation to impede your success. If a currency is inflating at five percent a year, then a year later you will need five percent more just to stay even. But some governments (including the United States) assess a tax on any capital gains you earn. So, if you want to keep up with the rotting of your money (inflation), you need to earn more than the inflation rate to cover the taxes. If you pay 33 percent in taxes, then you need to earn 7.5 percent in order to just stay even with five percent inflation. This is just an added burden, and another way for the government to collect energy from you
Currency Exchange Rates
Currency exchange rates reflect the varying value of different moneys. Remember that money is a STORE of energy, and that it’s value is determined when it is converted back into a product created by the energy of another person. If people suddenly become unwilling to accept your money for their energy, the products they produce become unavailable to you. People become unwilling to accept your money because they have doubts as to its future value (their future ability to convert it into the energy of others). These doubts sometimes arise all at once (as recently happened in Mexico) or gradually over time (as has happened with the U.S. Dollar). In both cases, people left holding the currency “give up” some of the energy they originally used to acquire it.
We will not go into a detailed tutorial on the currency and futures markets now. Just be aware that there are companies and individual speculators who try to predict the future value of a currency, and will buy or sell that currency in an attempt to make a profit. These speculators provide a valuable service by constantly pricing a currency and providing liquidity for those who need to convert currencies as a part of their business. The creation of derivatives have allowed these bets to become more and more leveraged and more and more intertwined. With derivatives, a price increase in cotton might have an impact on titanium prices, or vice-versa.
Currency exchange rates have little direct impact on the individual investor, since most of her purchases are in her native currency. However, to the extent that she buys imported goods (cars, gasoline, clothing) the changing value of currency exchange rates has an impact on her ability to convert money into products or services. Moreover, currency exchange rates indirectly influence the financial markets on a macro basis. As people evaluate their different options for storing energy, the weaker currencies will have to pay a higher interest rate to investors. Investors demand this in order to maintain or increase the value of their stored energy (money). Of course, rising or falling interest rates have an impact on the equity markets. They also have an impact on people expectations for inflation, and therefore commodity markets. Ultimately, all markets are interconnected.
Successful investing is staying ahead of spoilage caused by inflation, taxes, and currency devaluations. That is step one and many people do not even succeed that far. However, if you can manage to beat the three horsemen, then the goal is not to stay even but to get ahead. There are many paths and strategies to use to get ahead. Many are related to and investor’s style and temperament. Some prefer slow and steady, others prefer exciting gains and losses. See our section on Investment Style for more commentary on this subject.
Professional money managers often compare themselves against benchmarks and averages. This may be useful, because it tells us if they did better than some arbitrary average. If they can’t beat the averages (and most can’t), you would be better off throwing darts at the stock page than trusting your money to them. What none of the comparisons or averages can tell you is how much risk they are incurring to earn the returns they get. They may do better than an average in a good year, worse in a bad year, and worse overall. They may do better in a good year, better (lose less) in a bad year, and still not provide as good a return as a bank CD. Risk management is an inherent part of any investment strategy. To quote Warren Buffett “You can’t tell who’s swimming naked until the tide goes out!”. Worry less about beating the averages than about beating the three horsemen. They are the true enemy of your wealth.