Tag Archives: money

The two most important lessons in personal finance

I am gradually learning how to create clickbait titles. I think this one is a step closer.

There’s a lot of advice available on managing your wealth and most of it is rubbish. After thinking over several years about money, I have come to the conclusion that the following two lessons are the most important ones. Ignore everything else and abide by these lessons.

Lesson #1: Focus on earning; not on saving.

The following fact is true: the quality of one’s life is better measured by the total amount of money one spends as opposed to the total amount of money one saves. You enhance your life by spending money on life-enhancing experiences, not by stashing it in a bank account. And yet, 99% of advice on managing your money focuses on how to spend less on your groceries.

Just do the calculations. To make things slightly simpler, say you are 18 years old right now so that lots of career options are available to you. Let’s think about two versions of yourself. The first version puts in serious effort into finding the best career for your skill set and the second one half-asses an average career. What’s the difference between the average amount of money the two versions make per year? For any given skill set, if you start seriously optimizing your career at the age of 18, you can easily rake in upwards of a few hundred thousand dollars per year averaged over your life time. But with a half-assed career you will likely never make more than $100k. So that’s a difference of a few hundred thousand dollars per year. Now, let’s think about how much money you will save by carefully optimizing the grocery store you shop at. Suppose you shop once per week and save $100 every time you shop because your arduous research has found you the cheapest grocery store in town. Since there are about 50 weeks in a year, that’s $5,000 saved in groceries. Let’s be generous and multiply this number by five because you are doing the same level of optimization in your phone plan, your hair cuts, your clothes, and food. That’s still a mere $25,000. Comparing this to the rewards of optimizing your career properly, it’s clear which one is worth your time.

Things might be slightly different if you are older because your career is not very flexible any more. But most people spend way more time trying to save than trying to earn. I think at any age there is some reward to be drawn from shifting your focus from saving to earning.

In fact, for the benefit of the reader, let me make this really clear. I think even if you spend absolutely zero mental energy on saving on groceries, phone, cabs, and food, but are aggressively optimizing your career, you will do orders of magnitude better financially than someone who is aggressively finding the best deals in town but just picks whatever career comes his way.

Lesson #2: Realize that there are many different forms of wealth and most of them are interconvertibile.

Once a friend of mine told me that he only spends money on things that appreciate in value. This was his justification for not buying a car. Of course, if you buy a car and then try to sell it back, you will get less money than its original price. Thus with time, it’s value decreases. But if you buy Apple stocks, it’s very likely that you will be able to sell it for a higher amount in future thus making more money. So isn’t it obvious that you should spend money only on things like Apple stocks and never on things like cars?

The flaw in this argument is that it’s overly focused on one specific kind of wealth, i.e., money. Wealth comes in many forms, including time, convenience, happiness, relationships, pleasure, luxury, status, knowledge, expertise etc. Sure buying a car will reduce your monetary wealth, but that’s only because the monetary wealth is being converted into (a) time, because you will save on your commute, (b) convenience because now you won’t have to carry your groceries in the subway, and may be (c) status in case it’s one of those cars that enhance your status. Why should we look at these other abstract kinds of wealth? Because of the inter-convertibility of one form of wealth into another! Even if you only care about money, it will be easier for you to earn more money in future if you have time, convenience, and status in your hands now.

Many people ignore this when they drive 3 hours to go to a city where the discounts are 5% higher on clothes. Should you stay in your city and pay 5% extra or go to the next city and save it? Stated this way, it seems clear that you should drive to the next city. But the statement above does not represent reality. The real comparison is between 3 hours vs. 5%. Depending on 5% of what, the 3 hours might be more expensive.

A similar reasoning can be applied to going to elite universities. At the face of it, it’s just a sink of money. But why do people still go to university? Because even though you spend money in your tuition fee, you gain wealth in the form of a network of future successful people, and expertise in economically valuable skills. This wealth can later be converted into other forms of wealth, including money!

 

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The CEO paradox

This post is half-baked, and is perhaps just non-sense, but hear me out for a bit.

If there is a useful skill that can be defined precisely, then any competitive economy will converge to a point where that skill can be outsourced. This means the highest paid employees will always be the ones with the most vaguely defined skills.

People go on and on about why CEO’s get so much money even though what they do is not even very clear. The ambiguity of their skillset is perhaps the reason why they get paid so much.

Economics 101: Types of assets

(Disclaimer: I know nothing about economics.)

In the last post, I defined assets as anything that can be owned. Interestingly, this concept needs examples to be fully understood. In this post I will provide some examples.

Cars, houses, food, clothes etc. are obvious examples. These are all tangible objects you can hold in your hands. A vacation package to Hawaii is less tangible but no one will have problems accepting it as an asset. Let’s move quickly to the non-obvious.

A loan is an asset. Let me explain why. If you give out a $1,000 loan to your friend Bob at a 10% interest rate, you now own the right to receive $1,000 + interest back from Bob. This right is an asset, and therefore, you can do things with it that you can do with other assets. For example, you can sell it. Whoever buys it will get the right to receive $1,000 + interest from Bob. What value should the asset be priced at? That depends on many things including how reliable Bob is, what interest rate are the banks giving out loans for, and how good of a deal you can negotiate in your trade.

Similarly, many other contracts you sign with people can be considered an asset. A share of a stock is another slightly non-trivial kind of asset. If you own 1% of the shares of a company, you essentially own 1% of the company. Once again, you can exchange this asset with other kinds of assets and the price will depend on many factors including how valuable the company itself is.

The idea of treating contracts as assets has been used extensively in recent years in the form of something called derivatives. Derivatives are assets that are derived from other assets. For example, now that we have seen that a share of a stock is an asset, one can define a new asset called a “call option” which is the right to buy a share at a certain price at a specific future date. A call option is a derivative that’s derived from a stock. Being an asset, this contract can be bought and sold in exchange of other assets and its price is determined by several different market parameters interacting in complex ways. Similarly, for any kind of asset, you can sell the promise to buy or sell the asset at a future date at a specified price and that will be an asset of its own.

Next, we turn our attention to a unique kind of asset: money. Money is simply an asset whose role is to make trades easier to execute. Any object that a large community has collectively agreed to value can be considered money. Imagine you live in a society where money has not been invented yet. If you own lots of horses and you need some rice, in order to exchange horses for rice you will need to find someone who has extra rice and is in need of horses. Or if you are good at sales, you can sell your horses for rice to someone who doesn’t care for horses using the following sales pitch: “Why don’t you take my horses, give me your rice, and then sell these horses to someone else who has the thing you want? And since horses are in demand these days, selling them shouldn’t be a problem.”

This might work if horses were truly in demand (or if you were excellent at sales). This is where money comes in. This is what distinguishes money from other kinds of assets. There is some sort of probabilistic guarantee that money will always be in demand in the sense that anyone you talk to will be willing to accept your money in exchange for something else. How such a guarantee comes into existence is an interesting issue that will require a blogpost of its own. But for now, we will use this as our working definition for money: an asset that a large community has collectively agreed to value.

Finally, another interesting and often ignored asset is time. Everyone owns a certain amount of time and the thing that distinguishes time from other kinds of assets is the property that you cannot choose to not spend it. In fact, it is constantly being spent at a rate of one second per second and you can only choose what you are going to spend it on. Unlike money, for example, you cannot save it in a bank.

Once again, being an asset, it can be exchanged for other assets. The most explicit way of doing that is to take up a contractual job that pays you an hourly wage. But more indirectly, you are always converting time into other kinds of assets. If you spend four years at university getting a degree in computer science that later lands you a $100k job, you have in some way converted those four years into some sort of wealth.

At this high a level of abstraction, things become confusing and it’s not always clear exactly what trade is being executed, but I think there is a certain advantage in thinking of everything as an asset and every activity as a trade. Hopefully this will become clearer in a future post.

Wealth is not money

Money is just a kind of wealth. It is not wealth itself. Realizing this leads to some interesting insight.

Arbitrage

If you know that a stock is definitely going to cost $50 more one month from now than it is now, you will buy tonnes of it now, sell it a month later, and make a definite profit. But remember that wealth is not money. Thus if you know that a stock and an apple cost the same right now but are definitely going to cost different in future, you can once again make a definite profit. So if the stock is going to cost double in future, you sell an apple today and buy a stock. A month from now, you sell the stock and buy two apples. You have just converted one apple to two apples in a month.

Import-export

A country’s total import is always equal to its total export. Why?

If a person decides to, he can of course keep on buying things without ever selling anything. So if a person can do this, why can’t a country?

This one is a more subtle application of the wealth is not money principle. The point is to treat money as just another kind of wealth, i.e., to realize that every trade is a barter trade. When you are buying an apple for a dollar, you are selling a dollar for an apple. So there you go, even a person cannot buy without selling.

How to grow your wealth

So since everything one can own is some form of wealth, how does one grow it? There are two ways of doing it:

  1. Own more things.
  2. Somehow make people want the things you already own.

Similarly, there are two ways of losing wealth:

  1. Give away stuff you own.
  2. Make people hate the things you own.

The second point above restricted to money is called inflation. If you own a currency that people start disliking, you have been a victim of inflation.

This also means that being wealthy is a dynamic state and not a static one. Most people’s formula for being wealthy is to own a lot of money and stash it into a bank account. While this may work to a certain degree, it does not reflect reality. Being wealthy is really about owning lots of things that other people want. This is specially difficult since what other people want is a variable that changes constantly with time. Thus to really be wealthy, you need to constantly look out for people’s changing preferences and perform strategic trades to maintain a valuable portfolio.