Learn the theory of INVESTING

IN THIS ISSUE 

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THE THEORY OF INVESTING

The Theory of Investing are the unique ways wealthy people tend to think about investing.

The reason this is so important is because:

How you think about money dictates how you act towards money.

Here’s how wealthy people think about money:

If you spend money acquiring something that you expect to make you more than what it cost you, then we call that an Investment in an Asset.

If you spend money acquiring something that simply takes money out of your pocket, then we call that an Expense or a Liability.

So let’s use an example: Imagine we buy an ice cream machine for $100.

Is this an Investment or an Expense?

Well, it depends on what we do with the machine.

If we just use that machine to make ourselves a tasty treat every week, well, ice cream is great and all, but it’s not money going back into our pocket, so this is just an Expense in a Liability.

We’ve spent money and all we got out of it was ice cream.

But here’s the thing, it doesn’t have to stay a Liability. There’s two things we could do to magically turn this ice cream machine into an Investment.

First, we could start a business and sell ice cream for $1 of profit a cone.

Now, if we sell a hundred cones, we’ll have recovered our initial investment into the machine and have an asset that’s producing ongoing profit.

This is what we call a Cash Flowing Asset.

That is, it’s pumping out money to us on a regular basis.

The second thing we could do to turn that ice cream machine into an investment is to sell it for more than what we paid for it.

For example, if I can sell that machine in the future for $150, then ultimately that machine made me $50 more than what I paid for it.

This is called an Appreciating Asset.

SAVING MONEY

But what about Saving money?

Can’t you just stick it in a savings account at the bank or stuff it under your mattress?

Well, sure, you can do that, but what most people don’t realize is that they’re actually losing money when they do this.

And the reason for this is because: Saving is an Illusion thanks to a concept called The Time Value of Money, which simply states that a dollar today is worth more than a dollar tomorrow.

Here’s a thought experiment to show how this works:

Imagine you bury $100 in your backyard. That seems pretty safe and secure, right?

Well no, because what you can’t see is that ever year an invisible burglar slips into your yard and steals ~$2.50.

This burglar’s name is Inflation.

And this is a fundamental concept to understand why we invest in the first place.

See, inflation occurs for a lot of reasons, but one of them is because the cost of goods and services tends to increase over time.

This occurs because of an economic principle called Supply and Demand.

See, over time as an economy improves, people start to make more money. As they make more money, they have more disposable income which increases the total amount of Demand the marketplace can exert on products.

Now, if the Supply of those products doesn’t grow faster than the Demand, this means we have more people competing for the same amount of goods which leads to prices increasing.

Here’s what this means for you and your attempt to save money in the backyard:

If you dig up your cash in ten years, you’re gonna be shocked to discover that what could originally buy you $100 worth of stuff, is now only worth $75.

And the way to think about this is that you effectively spent $25 and in exchange you got to keep easy access to your money.

We call this access Liquidity.

Liquidity is one side of what’s known as The Magic Triangle of Investing.

THE MAGIC TRIANGLE

This triangle includes the 3 characteristics of every investment that you have to balance depending on your investment goals.

It includes Security, Profitability, and Liquidity. Or put another way, Risk, Returns, and Accessibility.

Now, the theory of the Magic Triangle of Investing says there’s no way to maximize for all three sides.

You can’t have a high return investment that’s also low risk and easily accessible.

There is always a trade off.

So let’s break down this Magic Triangle to understand how we can push and pull these different levers, starting with Liquidity.

LIQUIDITY

The easier it is to get to your money, the more liquid it is… but that easy accessibility comes at a cost.

For example:

Inflation is the price you pay for keeping your money under your mattress or in a checking account where you can access it at a moment’s notice.

One step up from this would be a high yield savings account where it might take just a bit longer to get your money, but in exchange you get some interest (historically between 1-2%).

Now, the thing to notice here is that your return is still below the rate of inflation.

Which means even in a high yield savings account, you’re still losing money over time because you’re paying for low risk liquidity which comes at the expense of a higher return.

So how much should you have in liquid?

And the answer for all of us is simply: It depends.

It depends on your individual context and what you’re hoping to get out of your investments.

A good rule of thumb is to have a couple months of life expenses liquid, and another couple in bonds or cashable equities, and the rest well…

Wherever you see fit.

RETURNS

When I first started learning about investing I read a book that had a profound effect on how I thought about money.

It’s a classic within the personal finance space called, The Richest Man in Babylon.

This is a fantastic book that I think everybody should read, and I think what I love most about it (besides the timeless lessons) is just how short it is. Shouldn’t take you very long to get through.

But within that book there was one concept in particular that reframed the way I thought about investing.

It’s this:

Think about your money as though they were workers whose primary job is to get you more workers.

This is called Investing, and the speed at which your workers bring you back more workers is your rate of return.

Now, this is great, but where things get really bonkers is when these new workers also start bringing you back more workers.

This has a special name that we call Compounding Interest and this might just be one of the most powerful concepts in the world of investing.

You’ll spend years with barely any progress because it takes a long time to get wealth going, but once it does, your growth will take off like a rocket ship.

To see a real life example of this look no further than Warren Buffett who is widely considered to be the greatest living investor.

If you were to plot out Warren’s net worth over time, you would see this incredible exponential curve that starts around the time he turns 50 years old.

Now, at this point, he’s been investing since he was 14 years old, so that’s 36 years worth of compounding and his net worth is right around $250M.

See, 40 years later, when Warren turned 90, that $250M had transformed into $100B.

And that is just such a big number that it’s really hard to even comprehend.

But what this really demonstrates is that massive wealth can be created by generating moderate returns that are compounded over long periods of time.

Time is an investor’s best friend.

So start investing as soon as possible and then whatever you do, follow Warren Buffett’s two golden rules of investing which is:

RISK

Let’s start by defining our terms: Risk is the likelihood of losses compared to the expected return on an investment.

Now, this is easy to say… but the reality is this Risk is incredibly difficult to measure because in the world of investing we’re never dealing with perfect information.

Which means we often have to make our own best educated guess as to what will or will not happen in the future…

This means that perception of risk in an investment is often subjective.

However, one of the really interesting things about humans is that while we will all probably guess a little differently, if you were to aggregate and average all the individual guesses, you would end up with a collective guess that is remarkably accurate.

Okay, so here’s what this means when it comes to investment risk:

The investment wisdom of the market as a whole, is generally pretty accurate.

Now when I say the market I’m really talking about the big three, which is the stock market, the bond market, and the real estate market.

So unless you are an extreme outlier with some unique skills and resources, you’re not going to consistently outperform the market…

So the vast majority of investors would be best served by simply trusting in the Wisdom of the Crowd and pursuing stable investment opportunities that historically have moderate risk paired with moderate returns (between 5-15% annually).

And this leads us to the last thing you really need to understand about investing. It’s this:

Investing is inherently risky.

There’s no such thing as a guaranteed return. None.

So the most important thing is that you don’t invest money you can’t stand to lose. If it’s your last $100, don’t put it in the stock market. Hang onto you so you can pay your bills.

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