We often hear the phrase "the time value of money," but what does that actually mean? Fundamentally, it means that money now is "worth more" than money later. For example, if I were to put $100 in a savings account at 1% interest, I would have $101 (not including compounding) at the end of a year. How can that be? How does money get more valuable?
It doesn't. The money itself, when there is no inflation or deflation, retains its original value. In order for there to be any return to money invested, it must be put to work. The only way money can be put to work is by using it to help transform one thing into another thing that is more valuable.
For example, if I take $100 to buy 100 plain wooden blocks and some paint, then invest my time painting the blocks for decorative purposes, I can sell them for, say, $120. The "extra" $20 is the result of my ingenuity and effort. I take cash, some raw materials, and my time and combine them to create value that did not exist before.
If I have an idea for creating such a product, but do not have enough cash on hand to purchase the plain blocks and paint, I cannot create value. A banker or someone else that lends money might recognize my idea as valuable and offer to lend me the money. Say I borrow $100 and agree to pay the lender $105 at the end of a year. I still make $15 on the enterprise. The bank also made money--$5.
This brings us back to our original example--the 1% return on a savings account. For nothing more than the trouble of depositing money in the bank, it pays me 1% It can do so only because it then takes my money and loans it out for 5% It can do that only because someone is willing and able to take that money and create more than 5% value with it.
Now, who makes the most money? We can figure this out by reasoning that a bank will never make money if it lends it out for less than it pays depositors. So the owner of the savings account necessarily makes less money than the bank. What about the business owner? If he/she makes less than the interest rate paid to the bank, that business is a losing proposition. In other words, the business has to make a 5% return just to break even.
This is of course a drastically simplified description of rates of return. The point is that the business owner has the greatest potential of making money. Note that I said potential. Business ownership entails risk, but it is essential for there to be a return on that $100 at all.
Whenever we invest our money, it provides us a return. Behind that return, there is a business, or multiple businesses, actually doing the work of creating value. If the investment is stable and strong, it can be a good strategy for providing for the future. It will never match the potential of a self-owned business, though, because too many other people take their cut first.
Wouldn't you rather get the biggest cut on at least some of your income? I would, and I'll bet you would too. Don't wait, start learning now.
Showing posts with label business. Show all posts
Showing posts with label business. Show all posts
Wednesday, June 24, 2009
Wednesday, February 18, 2009
What is an Asset?
Accountants, financial advisors, and the popular press talk constantly about "assets." Most people have only a vague notion of what an asset really is. My favorite definition comes from the book Rich Dad Poor Dad. An asset puts money in your pocket. A liability takes money out of your pocket.
Let's think about that a minute. What kinds of things take money out of your pocket? Well, that bass boat sure does. Unless you make a heck of a lot of money fishing, more money goes into the monthly payments and upkeep than comes out in the form of income. If you are like most of us, you don't expect any money to come your way on account of that boat. That, friends, is a liability.
This is not being judgmental, by the way. If you enjoy fishing, buy that boat by all means. As long as you have the money, live it up. In the case of a pleasure boat, no one really expects to make money. But what about your house? Haven't you always been told that it is an asset? The truth is, it takes money out of your pocket too. Even if you have paid it off, you are still spending money on upkeep, utilities, and insurance. That makes your house a liability. But don't you make money when you sell? Try that about now. And even if you could sell it, where would you live?
The only thing that truly counts as an asset is something that puts money in your pocket. Assets are money machines. When you put some amount of money in an asset, you expect to receive more money than you put in at some point in the future. There are two ways to accomplish this. One is for the asset to throw out a stream of money like, say, a savings account. (I know. It's not much of a return, but stay with me.) As long as you keep that money in the account, you earn money. Another example is a stock that pays a dividend.
The second way for an asset to make money for you is appreciation in value. Imagine buying a Silver Eagle coin for $15 and selling it six months later for $20. This type of asset makes you money, but you have to sell it to realize the gain. House flipping was a popular form of this type of investing until the housing market crashed.
A successful business is a tremendous asset. By building a business, you can realize both kinds of return. A business creates an income stream as long as you own it. If you build it the right way, you can also sell it at some point for much more money than you put into it. Another great thing about building a business is that you can put much more than just money into it. You can put your know-how, your time, your social network, and your creativity into it. The bank does not care what I know or how hard I am willing to work when I open a savings account. I park some cash and it works for me for the rate determined by the bank, end of story. A business gives me an opportunity to capitalize on things other than money.
It all comes back to value. All businesses operate on the principle of creating value that other people are willing to pay for. Many times, we vastly underestimate how valuable we are to others because we are stuck in the J-O-B trap. Chances are, you have much more potential value than you realize. Next week, we'll take a look at some ways to tap that hidden value.
Let's think about that a minute. What kinds of things take money out of your pocket? Well, that bass boat sure does. Unless you make a heck of a lot of money fishing, more money goes into the monthly payments and upkeep than comes out in the form of income. If you are like most of us, you don't expect any money to come your way on account of that boat. That, friends, is a liability.
This is not being judgmental, by the way. If you enjoy fishing, buy that boat by all means. As long as you have the money, live it up. In the case of a pleasure boat, no one really expects to make money. But what about your house? Haven't you always been told that it is an asset? The truth is, it takes money out of your pocket too. Even if you have paid it off, you are still spending money on upkeep, utilities, and insurance. That makes your house a liability. But don't you make money when you sell? Try that about now. And even if you could sell it, where would you live?
The only thing that truly counts as an asset is something that puts money in your pocket. Assets are money machines. When you put some amount of money in an asset, you expect to receive more money than you put in at some point in the future. There are two ways to accomplish this. One is for the asset to throw out a stream of money like, say, a savings account. (I know. It's not much of a return, but stay with me.) As long as you keep that money in the account, you earn money. Another example is a stock that pays a dividend.
The second way for an asset to make money for you is appreciation in value. Imagine buying a Silver Eagle coin for $15 and selling it six months later for $20. This type of asset makes you money, but you have to sell it to realize the gain. House flipping was a popular form of this type of investing until the housing market crashed.
A successful business is a tremendous asset. By building a business, you can realize both kinds of return. A business creates an income stream as long as you own it. If you build it the right way, you can also sell it at some point for much more money than you put into it. Another great thing about building a business is that you can put much more than just money into it. You can put your know-how, your time, your social network, and your creativity into it. The bank does not care what I know or how hard I am willing to work when I open a savings account. I park some cash and it works for me for the rate determined by the bank, end of story. A business gives me an opportunity to capitalize on things other than money.
It all comes back to value. All businesses operate on the principle of creating value that other people are willing to pay for. Many times, we vastly underestimate how valuable we are to others because we are stuck in the J-O-B trap. Chances are, you have much more potential value than you realize. Next week, we'll take a look at some ways to tap that hidden value.
Tuesday, February 10, 2009
What is Money?
If your answer is the green stuff in your wallet or purse, go to the back of the line. The paper we all carry is a facsimile, a representation--a marker, really, for real money. It is fake. It works well in the place of real money, but only under certain conditions.
The idea behind money itself is brilliant. We can imagine how the first humans developed the barter system--you make arrows better and I make blankets better. Hmmmm...maybe we could trade and both be better off. Free trade ranks as one of humanity's crowning achievements. As we grew in intelligence and sophistication, the barter system became cumbersome. If you did not happen to need blankets at the same time I needed arrows, we were out of luck.
Money was invented to "mark" an asynchronous exchange of value. That is just a fancy way of saying that one of us could store the value he/she had created for future use. Neat idea, huh? The only problem was what to use for a marker.
Not just anything would do. In order for something to serve as money, it had to be durable, portable, and rare. Durability allowed value to be stored safely. No good using a tree leaf if it disintegrates before it can be spent. Portability allowed the value to be transported over large distances, thus expanding trade to the benefit of all. Those two characteristics are fairly obvious, and real money over the course of human history has nearly always been durable and portable. But why rare?
Rareness is a desirable characteristic for money to have because it needs to represent the value that is created and stored by the holder. If we were to use any old seashell, everyone could become rich by going to the beach. Something is wrong here, though. How can everyone become rich by picking up seashells? The answer is, they can't, though our government believes they can. This is the primary reason we are all facing the biggest financial crisis in decades.
Money is not usable. We can't eat it, can't wear it, and can't cure disease with it. What we want is the value behind it. If I am sick, the only reason I want money is to purchase your services as a physician. That seashell is worth only what I can trade it for. If the supply in a particular economy (let's say a village) gets too high, its value goes down. Soon it takes a bushel basket full of shells to purchase what three shells would purchase before.
The reason shells become worthless is that anyone can get them without providing any tangible value to anyone else. Over thousands of years, two main materials have emerged that prevent such flagrant abuses of the idea of money--gold and silver. Yes, some people acquire wealth by digging up gold or silver, but it is a lot of trouble and the supply is limited. In a sense, the miners of precious metals earn their value by providing the rest of us with a solid standard of exchange.
Gold and silver became the only real money not because anyone decreed them to be so, but because people in general recognized them as money. Governmental interference came much later, mostly with undesirable consequences.
Today, our government is creating currency hand over fist. All this in the name of "saving the economy." Note that I said "currency," not money. Did you ever wonder where that now nearly one trillion dollars comes from? They create it out of thin air. It represents no tangible value whatsoever. Like the village I just spoke of, our politicians are going to the beach, gathering shells, and calling it money. Oh, and they force us to use it as money. That is why you see "This note is legal tender for all debts, public and private" on our currency.
Our nest eggs all got hammered last year because we were counting on currency. We all thought that we would be able to trade what we thought was money for things we will want and need when we retire. Not likely. If your portfolio was mostly stocks, bonds, and mutual funds, you have been had. If you thought that Social Security would allow you to at least buy food and shelter and that Medicare would pay your doctor bills, think again.
The good news is that we do not have to sit and take this. No, I do not mean storming Washington, much as I love to dream of that. I mean that living the life you want to live and being able to retire comfortably now requires more courage and savvy than ever before. Next week, I will explain why you must learn what assets are and how you can start creating them.
The idea behind money itself is brilliant. We can imagine how the first humans developed the barter system--you make arrows better and I make blankets better. Hmmmm...maybe we could trade and both be better off. Free trade ranks as one of humanity's crowning achievements. As we grew in intelligence and sophistication, the barter system became cumbersome. If you did not happen to need blankets at the same time I needed arrows, we were out of luck.
Money was invented to "mark" an asynchronous exchange of value. That is just a fancy way of saying that one of us could store the value he/she had created for future use. Neat idea, huh? The only problem was what to use for a marker.
Not just anything would do. In order for something to serve as money, it had to be durable, portable, and rare. Durability allowed value to be stored safely. No good using a tree leaf if it disintegrates before it can be spent. Portability allowed the value to be transported over large distances, thus expanding trade to the benefit of all. Those two characteristics are fairly obvious, and real money over the course of human history has nearly always been durable and portable. But why rare?
Rareness is a desirable characteristic for money to have because it needs to represent the value that is created and stored by the holder. If we were to use any old seashell, everyone could become rich by going to the beach. Something is wrong here, though. How can everyone become rich by picking up seashells? The answer is, they can't, though our government believes they can. This is the primary reason we are all facing the biggest financial crisis in decades.
Money is not usable. We can't eat it, can't wear it, and can't cure disease with it. What we want is the value behind it. If I am sick, the only reason I want money is to purchase your services as a physician. That seashell is worth only what I can trade it for. If the supply in a particular economy (let's say a village) gets too high, its value goes down. Soon it takes a bushel basket full of shells to purchase what three shells would purchase before.
The reason shells become worthless is that anyone can get them without providing any tangible value to anyone else. Over thousands of years, two main materials have emerged that prevent such flagrant abuses of the idea of money--gold and silver. Yes, some people acquire wealth by digging up gold or silver, but it is a lot of trouble and the supply is limited. In a sense, the miners of precious metals earn their value by providing the rest of us with a solid standard of exchange.
Gold and silver became the only real money not because anyone decreed them to be so, but because people in general recognized them as money. Governmental interference came much later, mostly with undesirable consequences.
Today, our government is creating currency hand over fist. All this in the name of "saving the economy." Note that I said "currency," not money. Did you ever wonder where that now nearly one trillion dollars comes from? They create it out of thin air. It represents no tangible value whatsoever. Like the village I just spoke of, our politicians are going to the beach, gathering shells, and calling it money. Oh, and they force us to use it as money. That is why you see "This note is legal tender for all debts, public and private" on our currency.
Our nest eggs all got hammered last year because we were counting on currency. We all thought that we would be able to trade what we thought was money for things we will want and need when we retire. Not likely. If your portfolio was mostly stocks, bonds, and mutual funds, you have been had. If you thought that Social Security would allow you to at least buy food and shelter and that Medicare would pay your doctor bills, think again.
The good news is that we do not have to sit and take this. No, I do not mean storming Washington, much as I love to dream of that. I mean that living the life you want to live and being able to retire comfortably now requires more courage and savvy than ever before. Next week, I will explain why you must learn what assets are and how you can start creating them.
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