Win the War for Money and Success

by Neil Jesani

  Velocity of Money

  You have heard the old axiom when investing of, “Not to put all your eggs in one basket.” This usually pertains to the wisdom of diversifying your investments in different areas to decrease the chances of any one investment not doing well. This is certainly true and we will be looking more at that in the next chapter. However, it also has another meaning. When you have money in one place, accumulating in one financial product, it is more susceptible to being eaten away by financial eroding factors such as fees, taxes, inflation, market dynamics, interest rate changes, and the performance of other investments. Think of it as a sitting target.

  On the other hand, money in motion creates more money. The velocity of money obtains a multiplier effect and moves faster than the eroding factors. Money should serve multiple purposes. Banks use the same money over and over again. This concept is the “velocity of money.” Let’s look at a simple example to illustrate both sides of the equation.

  You have $100,000 you want to put away. You decide to go the very safe route and put all of the money into a CD with a bank. The interest may be at an annual rate of 2%. For the most part, you will be taxed on whatever interest you earn on the CD. When taking out a CD, you are locked into a certain amount of time like one, three, or five years. For whatever the time period of your CD, you cannot do anything else with that money.

  Now see what the bank does with your $100,000. It could lend $25,000 out to a small business where they charge 8% interest to the borrower. As that person begins to pay back that loan, the bank starts using the money somewhere else. Now start to multiply that scenario and you see what happens. Out of your original $100,000, the bank uses another $50,000 to fund a second mortgage for someone. Maybe $15,000 goes for a student loan and the remaining $10,000 helps fund the bank’s credit card program. They lend all of your money out for a greater rate of interest than they are paying on your CD. As the money comes back in from those other loans, the bank immediately puts it to use elsewhere.

  Banks also have a unique advantage because they are only required to have 10% of the funds in the bank in order to lend out 100%. A bank isn’t really a safe holding everyone’s savings; it is more of a revolving door where money doesn’t sit still for very long. When all is said and done, the velocity of money means the bank earned 15-25% interest on your original $100,000 while paying you 2%!* That spread between your 2% and what they earned is how the bank pays for its staff, buildings, general overhead, etc., as well as making exponential profits. Money in motion makes more money.

  Now I know that large financial institutions have the resources to do a lot more than an individual. However, you can take a lesson from how a bank multiplies its assets and puts your money to work in a variety of ways. It is possible for you to derive a multiplier effect on your money in other secure ways that are safe and dependable. That is, there are many ways to put your money into motion. Here are couple of quick visual examples of putting money into motion using what’s called the “self-leveraging technique.” There are many things that go into this technique and one needs to consider many factors before putting a strategy like this into practice.

  *Plus 15-25% on its ability to lend out an additional $900,000 based on a 10% fractional reserve set by the Federal Reserve. Banks are more like slot machines that win 10 fold every time a coin is dropped into the machine. For more information read: https://www.managementstudyguide.com/how-fractional-reserve-banking-creates-money.htm.

  Here is another visual that shows the power of money in motion. You can put your existing savings and investments to second use by utilizing this strategy. Granted this illustration is meant for people with a certain income and net-worth but the concept works the same at any income level. It will be hard to understand without much context, and I do not want to take the entire chapter for this one topic, but it enhances your rate of return, creates tax-free income and minimizes the expenses of investments.

  How You Use Money, Not Where You Put It

  In the above example, I used only a few methods in which a bank takes your money and makes more money from it. In reality, there are many approaches to how a bank can lend out money in order to bring more into its coffers. The point is not so much what those methods are, but the fact that they utilize so many methods. If a bank used all of their money for home mortgages, their rate of return would not be much more than what they pay you for your CD. The bank may be able to operate this way, but if there is a downturn in the housing market, they might find themselves in trouble. That’s why banks lend and invest in many different types of categories.

  This is the approach you need to take with your money. It is there for you to use. The successful investor is more concerned with making the best use of his or her money rather than looking for that ideal investment to put it in.

  What do I mean by this? Many people are always looking for that one hot stock or new company or great investment portfolio as a place to invest. That shiny object syndrome becomes their guiding principle in trying to increase their wealth. This philosophy means that the investor is looking to meet a certain need or goal based on what they learn about that particular product. Rather than focusing on that, it is more productive to concentrate on the method you use in investing.

  Even if you are not a golfer, here is a simple analogy to illustrate this point. Some golfers are so sure that if they have the right clubs, or golf balls, or shoes that their game will improve dramatically. These players will think nothing of dropping $500 on the newest driver if they think it will let them hit the ball straighter and farther. Unfortunately, if he or she still hits the ball wrong with the new driver, they aren’t going to do any better than they did with the old club. Rather than sinking money into equipment, the player would be better off working on his swing, or learning course management, or how to hit good shots after hitting a bad one.

  Investing is the same. It is much more important to learn how to properly manage your money than it is learning where to put it. Don’t get me wrong; it is important to know where you are putting your money. However, once you know how best to use your money, the easier it will be to evaluate where to invest it. Managing your finances does not occur in isolated segments, but organically, where all the factors you need to know work together.

  Money Is Not Math, Money Is a Commodity

  In general, a commodity is anything that can be bought and sold and has a value. Often the value fluctuates depending on supply and demand and an entire host of factors. The other fact about a commodity is that its value can erode over time.

  Money is a commodity, just as much as wheat or iron is. When you use these commodities up, they are gone. If you are in a business that utilizes one of the two commodities I mentioned, you have to go out and look for more when what you have is gone. Without them, you can not bake bread or build automobiles. If you think of money in the same light, you will be ahead of most people on your way to securing financial success.

  We know that money is a commodity. It changes in value and can erode over time. It is impossible in the end to keep constant the mathematical assumptions used in the calculations of money decisions today. The mathematical assumptions include interest rates, investment returns, tax rates, and inflation rates. These factors are certain to change and drastically affect our mathematical outcomes.

  Let’s bring this together in one more illustration. You have three peaches in a bowl in your kitchen. You go to the store, buy another half dozen, and add them to the bowl. How many do you have? The math is simple: 3 + 6 = 9. As a mathematical problem, it is simple to solve with arithmetic.

  Now what if you left all those peaches there for ten years? How many would you have then? Mathematically you may still have nine, but in reality, odds are you would have none. A lot could happen to those peaches in that time. They might dry up and turn to dust. They could have been eaten before a week went by. The point is that they are a commodity that can deteriorate or erode over time. There are many differe
nt forces at work that could bring about a negative change to the peaches.

  Your money is no different. Money is not stagnant. Its value can go up or down. Forces of economics, national money policies, and various other factors will affect your money over time. This concept is very important to understand as you read spreadsheets of how an investment performed, or you are looking at its future projections.

  This is why we are spending a little time discussing the true value and nature of money. Too often, numbers are thrown around and it is easy to lose perspective of what they all mean. When you are dealing with your savings and investments, please keep in mind that those numbers represent a very real, significant amount of dollar bills. Never lose sight of that!

  Average Return Is Not Actual Return

  One of the sad truths in the financial world is that it is quite easy to manipulate numbers…and even math…to make something look better than it actually is. This is why you have to educate yourself on what you are reading or hearing about when evaluating an investment. While math is an absolute, it can be very easily used to give a false impression. Let’s look at an example of figuring out the average rate of return on an investment.

  For this example, you have $100,000 invested in a stock. In your first year, it does fantastic and you get 100% rate of return. You now have $200,000. Since it did so great, you let the money ride and the second year it loses 50%, and you are back to $100,000. You go one more year and it does another high earning of 100% rate of return. You are again at $200,000. Since you didn’t learn your lesson from two years ago, you keep the money there, it suffers another minus 50% rate of return, and you are back to $100,000. In four years, you didn’t make a dime.

  However, let’s look at the math. Over those four years, the total rate of return was 200%. You add together the two years of 50% losses and subtract the 100% from the 200%. Using that math, the money had a 100% rate of return over four years for an average rate of return over that period of 25% while the actual rate of return is 0%. Here is how it looks in the mathematical formula: 100% - 50% + 100% - 50% = 100%...100%/4 = 25%).

  As you can see, while the math is correct, calculating investments take more than basic arithmetic. The investment industry uses a geometric means of calculating such things as average rate of return that utilizes other real -world factors so that the figures reflect close to reality.

  Another concept an investor should know is the multiplier effect. Simply stated, if you sustain a 50% loss, you then need a 100% return just to make up that loss. This is illustrated in the example above. When the $200,000 got cut down to $100,000 in year 2 of the scenario, it took a 100% return the following year to get it back to the original $200,000.

  One of the critical points of investing is how well you manage losses. They are going to happen. You need to have a strategy in place to limit potential losses and know how to react when it does happen.

  As we continue discussing different investment strategies and products, look at numbers and statistics with a discerning eye. Quite often, numbers give you a snapshot of what is going on at one particular time. It doesn’t necessarily mean it is true over an extended time frame.

  Summary

  As you can see, the concept of money is not as simple as you might have imagined. First of all, a dollar is a dollar. It has a very real value that you have to constantly be aware of. From there, money becomes very complex. It can do many different things, often at the same time. The crux of the problem is determining how to best use the money you have. While you are not a large financial institution, you have many different options on how to save and invest your money.

  The concepts presented in this book are kept simple in order to present the complexities of saving and investing simply and understandably. As we are about to get into more specifics about investing and the various vehicles for doing so, you will see that each have their own particular traits. While it is important to understand them, they are impossible to master unless that is the business you are in.

  CHAPTER 5

  Factors Affecting Investment Return

  “It is more difficult to win in a stock market than to compete in Olympics.”

  Ray Dalio

  N

  ow that you have a better understanding of the nature of money, you have to decide how to make it work best for you. There is no one answer to that question. As we saw in the last chapter, it isn’t meant to be one answer, but many. There are so many factors involved including how much money you are working with, the time frame you are looking at, and your temperament when it comes to investing. A good rule of thumb is never do anything that prevents you from sleeping soundly.

  With all of the ways to invest, you will discover different pros and cons for each type. As you get a handle on your strategy, you need to know the different types of investments, how each is taxed, and how much it costs you to invest in something. So there are three main factors that will affect your return on your investment:

  1. Asset Allocation

  2. Taxation

  3. Expenses

  First Factor Affecting Return: Asset Allocation

  This is where you do not put all of your eggs in one basket. You want to balance risk versus reward by having an investment portfolio with a certain percentage of your money going to each investment type that you decide on. This is where your risk tolerance, goals, and investment time frame come into play as you decide on your investments.

  There are two kinds of investments we use for wealth building: 1) Short-term and 2) Long-term. The short-term wealth building investments are liquid assets, things like checking accounts, savings accounts, money markets and so forth for your emergencies, opportunities, security, and just overall peace of mind.

  Before we look at the return of long-term investments, let’s understand the underlying premise for all long-term investments. Why are we giving up current enjoyment of our income? The answer is to have a comfortable income stream in retirement and pass the left-over assets to family and charity in the most efficient way. It only makes sense then to understand how retirement income streams work so that we can direct today’s savings in ways that potentially gives us the highest income when we retire.

  In other words, how retirement income streams work defines how we should allocate our savings today. The sooner we get on an efficient path, the greater impact we will have on the results. There are two rates that make up everyone’s retirement income stream later on, and both are equally important. One is the accumulation rate – getting up the mountain. The other is the distribution rate – getting back down safely. Knowing how retirement income streams work and then how distribution rates work, is the basis for understanding how to save money in pre-retirement.

  While we will be looking at these in detail in subsequent chapters, here are some brief points about the various asset classes such as stocks, bonds, real estate, cash, commodities, and cash-value life insurance.

  Stocks

  In its simplest form, stock is ownership in a company. A business issues stocks to raise capital and you can own a certain amount of the company depending on how many shares you buy. You make money on the stock if the value goes up and you sell the stock. If you select a stock that offers a quarterly or annual dividend, or payout based on the company’s profits, you can also receive a dividend for each share of your stock if the company does well.

  You can either invest in specific companies or invest in a fund of stocks. This is a way to spread out your investment over many stocks in order to safeguard your money from any one company not performing well. These funds can be broken down by their investment strategy. Here are some of the most common categories and sub-categories:

  Index funds - In an index fund, the manager sets up his portfolio to mirror a market index — such as Standard & Poor’s (S&P) 500-stock index — rather than actively picking which stocks to purchase. It is surprising, but true, that index funds often beat the majority of competitors among actively managed fun
ds. One reason: few actively managed funds can consistently outperform the market by enough to cover the cost of their generally higher expenses.

  Growth funds - These invest in the stock of companies whose profits are growing at a rapid pace. Such stocks typically rise more quickly than the overall market — and fall faster if they don’t live up to investors’ expectations.

  Value funds - Value-oriented fund managers buy companies that appear to be cheap, relative to their earnings. In many cases, these are mature companies that send some of their earnings back to their shareholders in the form of dividends. Funds that specifically target such income-producing investments are often called equity-income or growth-and-income funds.

  Growth-and-income, equity-income, and balanced funds - Growth-and-income funds concentrate more than the other two on growth, so they generally have the lowest yields. Balanced funds strive to keep anywhere from 50 to 60% of their holdings in stocks and the rest in interest-paying securities such as bonds and convertibles, giving them the highest yields. In the middle is the equity-income class.

  Sector and specialty funds - Rather than diversifying their holdings, sector and specialty funds concentrate their assets in a particular sector, such as technology or health care. There’s nothing wrong with that approach, as long as you remember that one year’s top sector could crash the following year.