Surviving Financial Illiteracy – The Very Basics

“Did you just call me massive, naked and short? How rude!”

As part of the real survival series, I decided to write a bit about investing. I’m currently graduate student in Waterloo and generally considered frugal and sometimes on the edge of greedy. Being in the university it sometimes strikes me that the overwhelming majority of students here spend everything they have or, actually, do not have. Many of the undergraduates rely on a system of student loans and to many it actually does not occur very soon that they have to pay a significant chunk of it back.

I have been leading a study group for the past four months for the first level CFA examination that is coming up this December and want to blog a bit about saving and investing. Starting from various basic concepts about what money and inflation are down to different investments, saving vehicles and their (Canadian-) tax implications.

These are not recommendations but more of an experience report. I do not assume any liability for financial loss or any other loss that may be related to reading this article.

What is Money

(personal collection of several Silver coins)

Money, simply put, is any object or record that is generally accepted as payment for goods and services. Based on that principle it is accepted as medium of exchange, a unit of account, store of value and standard of deferred repayment.

Back in the old days scarce commodities were used to fulfill this option. People used anything from sea shells, barley, up to precious metals.

Over the years people moved to representative money, standardizing the unit size of the commodities used for exchange. Examples are various gold and silver coins that emerged over the centuries, for example the German Thaler that was first minted in 1518.

Today things are a little bit different. Common to all the previous examples is a very important property. All those items had a significant intrinsic value. What we have today is fiat money or so called paper money. Instead of having a significant intrinsic value it is a guarantee. Traditionally it was a guarantee to convert the paper into some physical commodity, but nowadays it is not. Instead governments govern laws on how this fiat money is used, replaced and traded. Fiat money is accepted as legal tender, making it unlawful not to accept money as payment for goods, services and repayment of debts. Therefore, it is actually a little more than “worthless paper” or “worthless electronic records”.

This concept of money also strongly ties into the concept of fiscal or monetary policy. Today most if not all countries have their money supply and rules associated with it controlled by some sort of central banking system. This system is responsible for:

· creating and destroying money

· and handing and taking that money to and from the government.

In almost all countries that money is only loaned to the government with interest. Therefore, setting…:

· this interest rate,

· the amount loaned and repaid,

· and reserve requirements,

also become part of that system.

It should be noted that those policies are usually influenced by macroeconomic indicators and are highly influential on inflation and taxation. The core objective of such a system is to ensure price stability. Making sure you pay the same unit of money for your daily items that you paid yesterday, the day before, a week ago and so on. Unfortunately, most of these systems have a poor track record at doing just that.

Inflation, Why Debt = Money, and How Money is Destroyed

Having introduced the central banking system, one may be quick to jump to the conclusion that this central banking system is the only source cause of inflation. It is true that printing a couple billion dollars directly constitutes to inflation, but the general effect is actually worse and it’s a bit more complicated. That has to do with how banks operate.

For hundreds of years banks operated on the principle of fractional reserve banking. In a nutshell it means that banks can loan out more money than they actually have deposited in their accounts. The controlling parameter controlling is referred to as the reserve ratio or reserve requirement and is also controlled by the central banking system.

So what does this have to do with inflation, one may ask. Let’s say the reserve requirement is 20%. That means a bank can loan out five times the amount of deposits to borrowers. Those deposits usually come from some money supplied by the central banking system and mainly from savings of the clients of the bank. Consider the following example.

Chang is a good guy and wants to buy an apartment from a local property developer, Bao. Chang goes to his local branch of dragon bank. For the sake of the example let’s assume the dragon bank, has 500.000 RMB in deposits. That means according to the reserve requirement 20%, the bank could loan out up to 2.500.000 RMB.

Chang is a good credit guy looks at a nice apartment in a red-hot Chinese property market, taking out a loan of 2.000.000 RMB out of his bank and down-paying about 500.000 RMB for a 2.500.000 RMB apartment.

He takes that cash and gives it to Bao, who now has 2.500.000 RMB in cash.

Now, for the sake of the example, let’s assume Bao has no accounts pending (i.e. the entire project was paid off) and is a savvy girl, who puts that money into her bank account of the dragon bank instead of investing it in new properties.

Wait what just happened?... Well, let’s look at the dragon bank again. Bankster Mei-Ching goes through her accounts. Previously she had 500.000 RMB in deposits and no loans. After giving the money to Chang, she had 500.000 RMB in deposits and 2.500.000 RMB in loans (earning a nice little chunk of interest on that one now). She is a lot happier now than before.

After Bao visted Mei-Ching to deposit her 2.500.000 RMB, Mei-Ching now has 3.000.000 RMB in deposit and 2.000.000 RMB in loans. That means Mei-Ching could loan out up to 13.000.000 RMB. Considering, the red-hot property market and the many other property virgins like Chang this is probably just going to happen, making Mei-Ching very happy.

Over just a few transactions the money that could be loaned by this particular bank increased by a factor of 5.2. Guess what, this is pretty serious inflation and it is not directly related with the government printing money.

Now be honest, did you know that before. After you wiped off your tears take a look at this one. It explains this system in the US in a very funny way.

So now after we illustrated how money inflates, let’s also take a look at an example how money is (or should be) destroyed. Let’s modify our example a bit.

Let’s say the money supply is the same and Chang still buys that apartment for 2.500.000 RMB putting 500.000 down.

Now let’s get a bit more realistic. Bao, the property developer is from a short legacy of very wealthy Chinese. She doesn’t want to go home to daddy without reporting triple-digit growth rates in for daddy’s apartment business.

Instead of depositing the money she got from Chang, she invests it into a set of new properties. Building an apartment, like the one that Chang bought, costs her about 500.000 RMB. So she goes out and builds 5 more apartments.

For the sake of the example, let’s assume that Bao greatly overestimated the demand, and nobody anymore wants to buy apartments anymore for 2.500.000 RMB.

The only people left in town would probably only be able to afford 75.000 RMB for housing. Having no reserves and being rejected by daddy, she has to do just that to survive, leaving her at an overall loss of 125.000 RMB. The math is as follows:

Bao got 500.000 RMB from daddy to start a property business (initial equity).
Bao invested 500.000 RMB to build Changs apartment.
Bao got 2.500.000 RMB from Chang for that apartment.
Bao invested all of her 2.500.000 RMB to build 5 more apartments.
Bao had to sell 5 appartments at 75.000 RMB each (daddy doesn’t like Bao anymore!)
Bao now only has 375.000 RMB.

500.000 RMB in deposits that were used to create 2.500.000 RMB in loans that was foreclosed to 75.000 RMB leaves Mei-Ching with missing 425.000 RMB to honour her obligations to the depositors, oops! If Mei-Ching does not get bailed out, an angry mob of savvy Chinese will soon be after her with torches and pitch-forks.

In total the money that was circulating in our little system, decreased from 1.000.000 RMB (Changs downpayment 500.000 RMB, Mei-Chings bank deposits 500.000 RMB) to 450.000 RMB (Foreclosed property 75.000 RMB, Bao’s equity 375.000 RMB). Note the value for the properties were not accounted for, since we are only talking about money at this point. But lets be assured even factoring in the property values, we have less than what we had before. I piced the China example, not because I’m an Asiaphile but because I particularly noticed these recent developments there…

Ours’ was a very scary example from a bust that actually destroys value and money. Considering the documentary it is actually not that far off the real risks. Usually the central bank would try to “contain” the system and attempt to “stabilize prices”. Following that objective through, they’d have to tweak the policies to make the apartments be priced at 2.500.000 RMB again. Be assured these policies will make several other things a lot more “expensive”, if salaries do not increase at the same time.

Time-Value of Money Calculations

So after we established what money is and, hopefully, believably convinced everyone that the value of money (or seen the other way round: prices) is not constant over time, we should look at some basic terms and concepts.

Interest rates are generally seen as time-value measure of money.

There are several specific concepts that should be mentioned with interest rates in general.

Required rate of return: is the interest rate that is needed for investors and savers to lend their funds. That is investors need to account primarily for risks, inflation and several other things.
Discount Rate: If someone borrows at interest X, he has to pay discount X in future.
Opportunity Cost: If you consume your savings now, while the interest rate of a bond is 5%, these 5% are the opportunity forgone.

Another nasty thing about interest rates for investments is that they are usually quoted in terms that mislead or exploit unsophisticated investors (or, worse, borrowers). Many investments generally state the annual interest rate and compounding intervals. For example, 3% annual interest, compounded semi-annually. Compounding actually results in a higher interest rate than you might think. This can be nicely illustrated by time-lines.

Let’s consider the interest payments as cash-flows (CF_1,…, CF_m) that occur at the certain compounding periods (0,…, m). The effective annual rate can be computed as follows.

Stated annual rate: r
Periodic rate: r/m
Effective annual rate:

This math assumes that the interest rate remains constant over the period of the investment. In practice however, this interest rate may vary and so do cash flows of other investments. Computing these returns over time can be nicely done by working out the returns over the time line. These timelines can also be nicely used to estimate the net-present value of future cash flows. For those, who want to dig deeper into financial calculus, take a look at perpetuities, and annuities. Almost any investment that involves periodic cash flows can be nicely valued with these tools.

Now that I scared you about the non-constant value of money, in future posts I will write a bit more about several investment vehicles.

References

Thomas's World

Saturday, April 2, 2011