Here I will introduce some of the fundamental principles of finance. I will dig deeper than most explanations of these concepts so that you not only see the principle but you can understand why it exists. Comprehending these insights will deepen your understanding which will in turn empower and guide your decisions. This is an exercise in who, what, where, why, and how.
A key to this comprehension is the fact that a purchase transaction, an exchange of value, in the final analysis, can only occur between two people. These people may represent any number of other people, but nevertheless, only two can attend to a transaction, no more and no less. By finding who those two people are, you will understand better what is happening. The more difficult it is to find out who they are, the more important that discovery is.
This fact is the basis of graft, theft, and extortion.
Money Has Value Only When It Moves
The funds represented by a number on your screen have latent value, of course, but they value is only realized when a transaction occurs. This demonstrates the fact that there is one pool of money and you administer a part of it. Money flows in and out of that pool when you make financial decisions. This makes your MyForeverBank a cash flow management system. The point is: it is completely under your control.
This fact is the basis of the financial principle called the “time value of money”. This is described much like a “bird in the hand is worth two in the bush.” In other words, a dollar today is worth more than a dollar in the future. You can’t spend future dollars and that’s because money has no real value until it moves. It may have tremendous potential value, but real value only happens when it moves, when it changes hands.
Interest
Interest is not as simple as you think, especially interest you pay to yourself and interest not earned on your portfolio. Let’s start with simple interest and walk from there to the other stuff.
If you have a savings account in a bank you are earning a small amount of interest on that account. You probably don’t think of that account as a loan to the bank, but it is. This fact illustrates a principle that applies to all financial instruments and processes: to understand a transaction, you must see it clearly from at least two perspectives. Typically, these two perspectives or points of view, can be disovered by mentally assuming the role of each of the two entities that are engaged in the transaction.
The Two Aspects of a Savings Account
You put your money into a bank’s savings account, and the bank pays interest at least yearly on that money. You see it as an investment, a sacrifice of alternative uses of that money (opportunity cost) that pays interest. Another viewpoint is that you are issuing a loan to the bank that pays you interest on that loan. You must be able to see both of these perspectives in order to really comprehend what you are doing when you make investments. This is a simple task with a savings account. The more complex the investment, the more important it is to sleuth out both ways of viewing the connection.
Negative Interest
We are going to expand your ability to understand finance.
When you open a checking account in an ordinary bank you put cash into that account. If the bank charges any fees then you are paying negative interest. Understanding why will expand your ability to understand finance.
You receive ordinary (positive) interest on the money you loan to a bank by opening a savings account. If the bank charges you for making a loan to it by opening a checking account you are paying negative interest. Now, you say, “But that money in my checking account is my money!” and you are right. However, the bank uses the aggregated checking accounts to make loans, so in a very real sense, you loan them your checking account as well as your savings account. (This is just one way the bankers played golf with their legislators and set up the laws to their advantage.)
Governments and Central Banks sometimes use negative interest rates to stimulate economic growth but that is beyond the scope of Bank-Free Banking.
Risk and Return
There is always a tradeoff between these two. Like a pendulum, the farther you push it to the left the riskier the investment, the greater the possibility of return and the farther you push it to the right the smaller the return but also the safer. This is a fundamental fact of finance and a reflection of a mysterious but well-established fact of human nature: our deep sense of value.
I have always marveled at the fact that two real estate agents who have no connection with one another will estimate the sales price of a building within a few percentage points of one another. I have observed this many times durig my long life. This mysterious human sense is at the heart of the free enterprise system and explains why that system will always outperform any planned economic system such as socialism. When we sold our home in Kansas and bought our off-grid property, two different agents suggested an identical price. Now, if the price had been less than ten dollars, the chance of this happening would be very high, but of course, it wasn’t.
Diversification
This is what we call not “putting all your eggs in one basket” because if you do and something bad happens to the basket, you lose all the eggs. Diversification, having at least a few different investments, is a way to reduce risk, often called a “hedge” against risk or loss.
Diversification can also help stabilize your portfolio. If you put all your money into stocks, then you at the mercy of the stock market. The ideal MyForeverBank will not be solely based on life insurance, even though it is historically the one instument that has proven to be the most reliable.
There are at least three ways to diversify: own various kinds of assets (stocks, real estate, etc), located in various geographic locations, and in various kinds of industries.
Liquidity
Liquidity refers to the ease with which an asset may be converted to cash.
This can also refer to the principle to be “light on your feet” so that you are free to take advantage of an opportunity in an instant. When my wife and I decided to go off-grid, she stumbled into a property that had a cabin on it but had been priced based solely on the lot it stood on. The real estate agents had advised the seller that it was in such bad shape that it should not be included in the selling price. Recognizing that the replacement value of the bad structure was at least $25,000, and, more germane to this discussion, the fact that it would sell very quickly, we immediately made an offer and arranged for the liquid capital (cash) needed to close the transaction.
The fact that it was in bad shape was the basis of the opportunity and, in the long run, only an inconvenience that was easily overcome by the advantages of the purchase.
Cost of Capital and Opportunity Cost
This fundamental principle of finance is so important and so often misunderstood or ignored completely that I have devoted an entire lesson to it. You’ll see it.
Compounding
This is a label put on the process used by some loans and some investments where interest is added to the balance and then the interest is again computed on that new balance, thus compounding the return on the loan (or whatever). Typically this happens at least once a year in, for example, a savings account. That is rarely labeled as compound interest. Only when it occurs during a year does it get this name.
Efficient Market Hypothesis (EMH)
This is the back side of psychology, the driver of bad and good decisions. The principle is simply that if you have all the facts, you make better, more precise decisions. It is why two real estate agents end up with the same price when they each have all the facts.
This principle is also at the heart of free enterprise. Freedom of speech allows us to say what we actually think without bias. If laws and regulations have to be considered along with value estimations, things get complicated. The more regulations, tax laws, etc, involved, the more complex the proposition and the less precise (less efficient) the work of establishing a price. When a great many transactions are encumbered with these forces that warp judgment, the whole system stumbles.
That has been the role of recent government: to inject artificial signals into the economy so that free enterprise is less and less free and the fine-tuning that should occur in the economy is corrupted making it less efficient.
Psychology
Fear of missing out on an opportunity and fear of loss are two big fears experienced by people trying to build a fortune, however big or small. When seeing that an investment is going bad, they are hesitant to sell it at a loss (because that locks in their loss) so they hang on too long and often lose more.
Fear of losing potential gains is actually just another version of the basic fear of losing, but I need to point it out so you can recognize it when it comes to visit you in your quiet moments.
The important aspect of these fears is that human beings feel negative emotions twice as intensely as positive ones, so these fears get twice as much attention as feelings of confidence. I takes experience to learn to read your own mind and heart, but if you pay attention to your feelings as you go throu and spend some time in front of a mirror asking yourself the hard questions you don’t want to answer, you will learn as you become more comfortable in your own skin.
There are a number of psychological challenges that we could discuss here, but these fears are the most challenging. I want to list all of those I can think of an comment on them.
- Herd Mentality – putting confidence in what everone else is doing.
- Recency Bias – Becoming overfocused on news or new trend.
- Greed – This can lead to excessive risk taking.
- Overconfidence – This may be overconfidence in one’s skill, a market trend, or a recommendation.
- Confirmation Bias – We tend to look for information that confirms our wishes and avoid information that tries to warn us of possible trouble. This is another propensity that adds to the fact that we can be our own worst enemy.
The cure for all these psychological challenges is to become a cold, calculating, cunning creature. An important character in the New Testament had this advice: “… be ye therefore wise as serpents, and harmless as doves.”
I know this will sound corny but it works. Use your imagination to put yourself into the character of a cold, calculating, yet wise and careful person like you were going to be that character in a movie. That will give you the spirit of such a person and color your thoughts and judgements accordingly.
You may think that all this time I spend talking about the human side of investing is unnecessary, but the fact is that anyone who wants to can learn all the academic principles of successful investing yet to be successful requires much more than knowledge. It requires discipline, patience, vision, and tenacity not to mention what we are covering here: objectivity, balance, and a. positive outlook (on the whole of the project of successful wealth building, not any one investment).
He writes from a background as a family man (raised ten children) with degrees in Physics, Mathematics, and Business. HIs vocation has been mostly Engineering and Financial Business, Accounting and Banking software. He is a Christian, a Philosopher, and an Author writing mainly about rights and government. He lives off-grid most of the year in the tops of the Rocky Mountains.
- Fundamentals of Finance - February 19, 2025
- How to Be a MyForeverBanker - February 19, 2025
- Cost of Capital - February 17, 2025
