The goal in finance is to spend less than you earn and invest the difference. Every financial instrument arises from this truism.
AXIOM #1: The goal in finance is to spend less than we earn and invest the difference. This is financial wellness.
AXIOM #2: We build toward the day when all our spending can be covered entirely by our investments. This is financial freedom.
AXIOM #3: Once earnings from investments can cover all expenses, the excess can be re-invested indefinitely. This is self-sustaining or dynastic wealth.
The fastest path to financial freedom is to invest as much as possible, as early as possible, and as often as possible. Invariably, this means spending less or earning more: or both!
So what is investing?
Investing requires us, who earn more than we spend, to give our extra cash to others: who spend more than they earn.
We invest in borrowers.
Borrowers take investments against their future earnings. They don’t have money now, so they offer to pay future income in order to receive their earnings earlier. But! A caveat: borrowers should only borrow to invest back in themselves. Investing borrowed money in others can be dangerous.
Definitions
As investors, we are never certain we will be paid back by borrowers because borrowers may never begin earning more than they spend. This uncertainty is called risk.
To pay for our uncertainty, borrowers pay us back more than we invested. This extra payment is called interest, and helps us break even when some of our borrowers fail to pay back our investments.
The more investments we have, the less uncertainty there is. If one borrower fails to pay us back, we still have plenty of other borrowers to make up the difference. This is called diversification.
Investors who don’t want uncertainty can pay other investors to accept uncertainty for them. This is called insurance (or hedging risk).
We pay the insurer now so if an investment fails later we can still receive some of our investment back. The insurer uses all insurance payments from each investor to pay back any one investor’s failed ventures. The insurer uses these payments to spread risk across lots of investors, reducing the overall uncertainty for everyone.
Sometimes one investment looks better than another, but uncertainty makes it difficult to judge the truth. We only have enough money to invest in one, so we have to choose. This is called opportunity cost.
If your money is already tied up in other investments and you want to spend it, you have to find a way out of your existing investments. Sometimes you have to pay to get out quickly — or you might have to borrow! The ease of turning your investments into spendable cash is called liquidity.
Liquidity reduces opportunity cost because it makes it easier to change your mind. It doesn’t matter if one opportunity is better than another if it costs nothing to switch your money between the two.
Fundamentally, all problems in finance are problems of increasing liquidity (borrowing), increasing potential return (investing), or reducing uncertainty (insuring). This is the borrow-invest-insure cycle.
While the last 30 years of financial innovations have primarily attempted to address the relationship between return and uncertainty on behalf of institutions, the average consumer today has more pressing problems with liquidity. What is there to be done about that?
Tune in next time for thoughts on the financial innovations ecosystem.