The most interesting thing about investment professionals is how few of them actually know the difference between money and wealth. If one wants to be generous, one can put that down to being so close to the tree trunks that one often fails to perceive the forest all around (after all, the tech fund manager is paid to watch tech stocks, not worry about oil prices). The problem for investors is that a broader perspective is crucial to constructing a wealth building program that will deliver the resources in the long run to meet one’s long term financial obligations.
When we started the Fund King blog, I thought of writing a very deep piece about what money really was and how that related to wealth. When investing, money is obviously an important tool but the actual long term goal is to build wealth. That is why we have structured the Fund King Website not as a “Hot Tip Sheet” but rather as a System for achieving solid long term positive investment returns. The System is important; the actual investment vehicles are just a means to an end. It is a top down look or, if you want to stick with the imagery in the previous paragraph, we are more concerned with the shape and size of the forest than any particularly attractive (or ugly) looking tree.
Although I never got around to my piece on the nature of money, I was reminded of the relationship between money and wealth by a video series from a leading Internet Marketing guru named Eben Page. Although he starts from very basic first principles, his handle on the subject is very close to my own, which either means we are both very right or very wrong. Now, a word of caution: these videos are part of a massive Internet Marketing pitch. The standard format is to offer some solid free content to entice you into plunking down serious four and sometimes five figure fees for a more extensive training course. I think the free videos are enough to get one started but if you want to go whole hog…Caveat Emptor and I have no financial interest either way.
What is Money?
Simply stated, money is a medium of exchange. Up until the last century, money was usually associated with a rare commodity that was easy to carry (although certain Polynesian Islands were known to put great store into large rocks that were too big to move). The key was to have something that all market participants could accept as a store value and be useful to grease the wheels of commerce. Since people worked for money, that has led some economists to define money as a call on future labor. This concept makes sense when you think about the actual components of value added in any service or product. Even something as commoditized as a barrel of oil would never make it to the refinery or your fuel tank without a massive element of labor to find it, bring it to the surface and transport it to the refinery. Some of that labor is now encapsulated in capital goods like oil derricks and supertankers but even those came into existence only as a result of the application of healthy doses of labor (as well as capital and materials but you can see how it all gets very circular). How does that work for most people in modern society? Well, when one is young and enthusiastic, one trades labor for money. As one becomes more proficient and productive, the amount of money for a given unit of time increases and most people manage to accumulate a bit of a surplus. After one retires, one can run down that surplus to buy labor from others (at grocery stores, restaurants, hospitals…). The picture is complicated by Government transfer payments like Social Security but for simplicity’s sake, we will stick with the standard and simplified “life cycle” view.
As soon as trade regularly occurred with counterparties “over the horizon” rather than in face to face transactions, money needed to become more mobile. Paper money redeemable in metals, letters of credit and loans were the innovations that helped drive the Renaissance and create the wealth that helped Europe dominate world affairs for 500 years.
As our economy has evolved, globalized and entered cyberspace, the actual nature of money has kept pace. While members of the Austrian School of Economics (of which I am generally a fan) will rail against the evils of fiat money (which is often characterized as “paper money”), a quick look at the M1 vs. M3 figures at Shadowstats.com will show you that less than 15% of US dollar money supply is actually composed of what most of us think about as money. The rest is 0’s and 1’s which are stored on computers and zipped around the world at the speed of light.
In fact, the way money is created in normal economic times is actually not by the government but by private banks engaging in fractional reserve banking which involves holding a fraction of depositors’ funds in the vault and hoping that everyone doesn’t show up on the same day to withdraw their money. When Christmas rolls around again, pay close attention to the Savings and Loan scene in “It’s a Wonderful Life”. The only difference between then and now is that the US Government has spread the risk evenly to all existing and future taxpayers while bankers rarely feel the need to head for a bridge when things turn sour.
Although money is a store of value, it is not a cost free. Even in the absence of inflation, the value of a dollar today is higher than that of a dollar tomorrow. This is called the time value of money and a whole structure of interest rates are available to put hard values on how much must be received to avoid the deterioration of a dollar into the future. Ask anyone who has run up a substantial credit card balance about the cost of spending money today (I only had to do it once to learn my lesson). Add in inflation, and the value of a future dollar is almost guaranteed to be significantly less than the value of that same dollar today. But what about deflation? While deflation would be the reverse and make future dollars more valuable, the political ramifications are too unpleasant to contemplate. The only real deflation that we have experienced over the last few decades has been that of computing power. How often have you bought a computer or flat screen TV only to see the same or improved model on sale for less in a few short months? Now, imagine a whole economy like that and you can start to understand why the Japanese are such reluctant consumers and have seen their economy stuck in neutral for two decades. When Ben Bernanke says it won’t happen in the US, you can believe that he will do his utmost to deliver on that promise.
What is Wealth?
Wealth is an asset that produces income in the future. That income may be hard to perceive today which is what gets both growth and value investors out of bed in the morning. The asset can be a hard asset like a factory or a piece of real estate or it can be more ephemeral like software or a business process like McDonald’s. Taking it one step further, an income producing asset is almost always a system for creating value. Whether that is a business process or an investment process, the key is to find a vehicle for creating value on a sustainable basis. That vehicle is what constitutes wealth. If it is valuable enough, we can use it to create the money income we need or we can sell the asset itself when we need to.
When you look at lists of wealthy people, they do not say that Bill Gates or Warren Buffett or the Sultan of Brunei actually has so many billions of dollar bills or gold bars stacked up in a vault somewhere. These billionaires (and the estimated 20m millionaires beneath them) have estimated their wealth in money terms for the purpose of calculating a number. In fact, if Bill Gates were able to dump all of his Microsoft on the market in a hurry, one would expect that he would have to take a significant haircut. The fact is that while we measure wealth in terms of money, real wealth is rarely kept in what we would view as actual monetary instruments.
The purpose of investing is to trade money for assets that can, at a later date, be converted back into money when we need it.
In the financial asset world, there are any number of assets on the shelf which one can buy. The problem is selecting the assets that will help you reach your investment goals. Some assets will be too illiquid. Some will be too volatile and some will just plain stink. Although some investment gurus have proposed that there are no bad assets just bad prices, there is enough fraud and stupidity in the market to justify the claim that some investment opportunities are actually just bad.
So what should an investor do?
The first thing one should do is recognize the difference between money and wealth. Money is a critical factor in acquiring wealth and one can certainly measure wealth in monetary terms but they are not the same thing. Holding money imposes an opportunity cost on our overall portfolio, particularly at the low interest rates that prevail throughout most of the developed economies.
Therefore, we think one should develop a system to turn money into productive assets on a systematic basis. The first part of that puzzle is usually but not always a systematic savings discipline. But once one has accumulated money as capital and one is ready to turn it into productive assets, one needs a systematic plan to make, manage and monitor the assets. Obviously, we think the Fund King System is a good way to approach this conversion and management process but it is not the only system out there.
As an investor, it is critical to take control of your investment process from the capital accumulation through to the capital deployment and measurement processes. If managed correctly, the result should be a level of wealth that will help you meet your financial obligations and perhaps have a bit left over for your family, charities and other good causes.