Money Miniseries #10

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The Least Understood Money of All
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Happy last day of 2014!

I’ll have some words to say about the New Year tomorrow, but for today, we’re going on with the next Money Miniseries which is on…

Investment…

I know, I know. It’s daunting.

Not only is it the least understood method of making money, but it is a method that nearly everyone accesses. Often times, depending on the investment, it is also the method in which we have the least control and we personally take on the most risk.

Even if you’re not investing in stocks, bonds, or mutual funds, as long as you have a retirement account or participate in a program similar to the US Social Security, then you are an investor.

Because it is so poorly understood, most people trust someone else to manage their investments. Someone like my former self.

As all of you in the Practical LOA newsletter know, I started out being an employee but it was my job to trade and invest hundreds of billions of dollars every single day.

There is a lot I could talk about when it comes to investments, but for now we’re going to keep it simple. And I’m going to reveal to you a way of thinking about investments that I promise you haven’t heard before.

So let’s get started…

No matter what form the specific investment takes, it will always follow a general format: exchange money for an asset, something that has the potential to generate more money in the future.

So, investing is basically the act of giving money today for the hope/promise of more money in the future.

Assets, then, can be anything that has the potential of generating money in the future.

They fall into 3 broad categories:

Real assets:	anything tangible such as cattle, metals, commodities, oil, real estate, and businesses
Paper assets:	documents that give certain legal rights to real assets
Intellectual Property:	creations of the mind such as music, books, inventions, brands, and designs

To understand how to increase our Flow of Money in investments, we go back to our trusty question:

How does the appreciation flow?

And that’s where it gets tricky. It can be difficult to track how appreciation flows with Investments.

That’s because much of the investing world is actually gambling.

And as we talked about in Money Miniseries #4, gambling is not one of the ways to Flow money. It is a way of Hording money and actually stops the flow of appreciation and money, which one reason many people end up losing money while "investing."

So how does appreciation flow through investments and how do we tell if investing is actually gambling?

Finding out how the appreciation flows through a particular investment is the key to understanding if it is actually an investment or a gamble.

Here are a few rules to help you decide:

1) Investing is a plan, not a prediction.
A gambler buys stock XYZ at $10/share because he thinks it will go higher.

But doesn’t an investor buy it for the same reason? Yes and no. An investor doesn’t actually think that the stock will go higher; he sees the potential for it to go higher. Since he knows that it’s just potential and not a guarantee, he makes a plan that could look like this:

Buy XYZ at $10.
IF XYZ goes down to $9, sell it.
IF XYZ goes up to $15, sell half of it. Then re-analyze and plan XYZ
IF it goes back down to $13, sell the rest of it.
IF it goes up to $20, sell the rest of it.
As long as XYZ stays between $9 and $15, do nothing.

You see, the investor does not try to predict anything. He simply plans for every possible scenario. If it does this, I will do this. If it does that, I will do that.

The gambler has no plan. He simply buys in hopes that his prediction will be right.

2) Did price go up because of value that was created? Or was the price speculated? Or was it Inflation?

One of the common themes amongst the methods of making money has been this:

To increase the Flow of Money, increase the reasons for which people have to appreciate you. And to increase the reason people have to appreciate you, deliver value and solve problems.

So when looking at an investment, we need to find out if value was created. The other two, price speculation and inflation, are always present… but value creation is not.

For example, in the years following the Financial Crisis of 2007-8, there was a lot of talk about “investing” in gold. The Central banks were printing too much money, advocates argued. That would devalue the currencies, so everyone should “invest” in gold.

In this example, where is the value created? There is none. Yes, price could (and it did) go up because of the flood of newly printed currency. But that’s inflation.

And it went up because people anticipated that it would and rushed to shift their asset allocations. But that’s speculation.

What value did “investing” in gold actually create? Whose lives got better because of it? Who had reason to be appreciative?

Those who bought gold at the time were not actually investing…

They were saving.

Gold’s value is intrinsically stable. What people were actually doing was this:

Today I saved up $1200, representing about 120 meals for myself and my family. I have no need for 120 meals today, so instead I buy a piece of gold. In 10 years, I have a need for those 120 meals. But now, meals cost $20 rather than $10 because of inflation. Had I saved my money in currency, I would now only have 60 meals. But because I bought a piece of gold and its price grew with inflation, I sell it for $2400 and I still have 120 meals.

That’s saving, not investing. And in saving, there’s no one to be appreciative except you, yourself.

3) What problem does it solve?
Whenever a problem is solved, appreciation flows. The larger the problem, the more the appreciation.

So when investing, we can ask what is the problem being solved and how big is that problem?

For example, if I buy a US Treasury bond what problem is being solved?

Well, the US Government continues to operate with an imbalanced budget, piling up its debts. In order stay running, it needs to borrow money. It does this by selling US Treasuries. So by buying a US Treasury, I am helping keep the US Government running.

How big is the problem being solved? Well, the problem is huge, but what’s my contribution to it? Honestly, buying a single bond at $1000 probably only keeps the US Government running for another half second. Probably less. So the appreciation (from the US Government) is small, and my return is small.

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Summary
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All right. Despite my best efforts, that turned out to be a giant newsletter. So let’s summarize:

Where’s the appreciation? If there isn’t any, it’s gambling, not investing.
For there to be appreciation, value must be Created and/or problems solved.
Investing is a plan, not a prediction.

Happy New Year, everyone! Be safe and have fun tonight!
Kane