Investment Basics

How often do we think about money? I don’t mean how we make it, save it, or spend it, but how it works. If you have a twenty-dollar bill sitting on the table, it appears to be a flat, inanimate object. However, money is not a stagnant object. It has a liquidity that is very robust and an understanding of how this works with your investments allows you to make better decisions about how to make you money work for you.

Velocity of Money

Money is always on the move. In your mind, you might think you have your money just sitting in a bank CD or a brokerage account, but that is a fallacy. A basic principle of money is that money in motion creates more money. This is the velocity of money and banks understand this principle to thrive and increase their worth.

Let’s take the example that you have $100,000 you want to save and you take out a CD with an annual interest rate of 2%. You lock it away for three years and cannot access it during that time. That is not the case for the bank. They use that money in conducting business.  It could lend $25,000 out to a small business where they charge 8% interest to the borrower. It then 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 somewhere else.

This 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 their 20% is how the bank pays for its staff, buildings, general overhead, etc., as well as making a profit. Money in motion makes more money. While you do not have the flexibility of a large financial institution to act as they do, you can take a lesson from how a bank multiplies its assets and apply it to your own scale.

How You Use Money, Not Where You Put It

People are always looking for that one hot stock or new company or great investment portfolio as a place to invest. That becomes their guiding principle in trying to increase their wealth.  This philosophy means that the investor is looking to meet a certain 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.

When investing, it is more important to understand how to properly manage your money rather than learning where to put it. 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

When looking at different investment opportunities, it is quite easy to manipulate numbers…and even math…to make something look better than it actually is. For example, you have $100,000 invested in a mutual fund. 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 lost 50%, and you are back to $100,000. You go one more year and it does another banner job of earning 100%. You are again at $200,000. Since you didn’t learn 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.

Now, let’s look at the math. Over those four years, there was a 200% rate of return. You add together the two 50% minuses and subtract the 100% from the 200%. Using that math, the fund 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%. The fund can truthfully proclaim this, but the reality is different depending when you invested in it.

The math is correct, but 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 reality. As you look for the best way to make your money work for you, be sure you are working with an experienced and trusted advisor that will explain to you the actual parameters of an investment and how it will affect you.