Most of what we do nowadays involves money. Once upon a time, we used to barter, but now almost always use money. When you go to the doctor, you give him cash, not some bread or meat. We give alms to the poor in the form of donations to charities. Food banks do not take left over scraps of food any more. You have to give sealed packages of specific types of food, which are purchased at a grocery store.
The reason money is has become such a central part of our lives is that it is simple. Money lets people understand the value of goods and services in an easy way. You know that a gallon of milk and gas are about the same price. You know what you earn in dollars, and therefore you can figure out how many gallons of milk you could buy with your paycheck. It’s all just simple arithmetic. Something we learned in elementary school. If Mary has three dollars and an apple costs fifty cents, how many apples can Mary buy?
Yet money is terrifying to many people. The word “finance” can send people screaming from the room or cause them to fall into a stupor. To me this is a tragedy, in the traditional meaning of the word: if you hide from basic economics, you will be lorded over by people who claim to know about finance. It’s no different than a shaman (aka. medicine man or women) controlling your access to the spirit world and therefore your health. As we know shamans had no special powers. It was all a mirage. The same is true about money people. They are fakes, and have no special powers over money.
If you care about your family and future, you need to learn about money. Finance is much less complicated than communicating with the spirit world. You do not need rattles, herbs, special rituals. All you need is a simple calculator which can add, subtract, multiply, and divide.
The Four Concepts
Money people love inventing new terms. Like shamans, the more names for a thing they have, the more confusing it is for outsiders. As we have seen recently, new terms like the now infamous “credit default swaps”, do not change the nature of finance. They are designed to hide the fact that money flows two ways: in and out. If you have more money going out than coming in, you go bankrupt as Bear Stearns and AIG did.
The inflows and outflows are divided into four concepts: revenues, expenses, investments, and other people’s money. The differences between these terms are easy to understand. I’ll go through them one at a time, and then summarize their relationship. I’m not trying to teach you how to make more money. My goal is to lay the economic foundation needed to understand investing, which I’ll discuss in another article (to be written).
An expense is money you spend which you do not expect to get back. Food, clothes, rent, and entertainment are expenses. Interest on your mortgage is an expense, too. The $10,000 in taxes per person we paid to support Wall Street firms is an expense. We do not expect Wall Street to pay us back. If they do pay us back, it will only be part of what we gave them. Gambling in Las Vegas is an expense. You are guaranteed to get back 97% (or whatever), but that means the 3% you lose on average is an expense.
Revenues are the opposite of expenses. When you pay an expense, someone is earning revenue. Your paycheck is revenue to you and an expense to your employer. If you sell some junk on craigslist, it is revenue. If you bought a couch it was an expense at the time of purchase. If you sell it later, it is revenue. The same is true for cars, jewelry, investment education seminars, etc. Some people might call these invesments, but they aren’t. The next section expains why.
When money leaves your wallet and you expect it to come back plus a little bit more, you have just made an investment. Of all the things most people buy, a house is probably the only investment, and some might argue it is simply a luxury the finance industry wants you to think is an investment. Certainly, the many people during the recent financial crisis who owe more than they paid on their houses are not thinking of them as investments now. You may get some of your money back when you sell your car, but you will not get all of it back. If you add in the expenses required to maintain your alleged automotive invesment, such as parts, labor, taxes, and insurance, it is even more clear that you get less back than you put in.
The golden rule of money is:
revenues minus expenses equals profit or loss
If you spend more than you bring in, you are losing. This is what happened to many companies and families in the recent past. No one escapes the golden rule of money. It is a law you can bank on just like gravity.
Other People’s Money (OPM)
The main reason so many people lost money recently is that they confused other people’s money (OPM) from their own. Finance people love OPM. Bernie Madoff loved OPM but was as confused as Joe the Plumber about what was his and what was theirs.
OPM is an investment to the other people in OPM, and these people can be divided into four categories: family, friends, fools, and investors. In the business, people talk about FFF money. I like to include the four category (investors), because they do exist, and it is wise to pay attention to them. Warren Buffet is an investor and the second richest man in the world. The fact that he is so wealthy is no accident.
Most people who supply OPM are one of the FFFs. They loan money to family when they are in need. Friends stump up for other friends. And, fools give their money to people like Bernie Madoff, AIG, Bear Stearns, Country-Wide Insurance, WebVan, and a host of other companies run by charlatans.
OPM is the flip side of investments, just like revenues and expenses reflect each other. Every dollar you spend is a dollar of revenue for somebody else. Every time someone invests money, it turns into OPM for a company or person. The difference between OPM and revenue is that OPM has to be paid back, one way or the other, or you will end up in jail like Bernie Madoff or bankrupt like Bear Sterns.
OPM is good
People love OPM, and it is what makes most of the world go around. From Grameem Bank in Bangladesh to Kleiner Perkins in Silicon Valley, OPM is a force for good in this world. I bought my house with a mortgage. People invested in my business. I have lived a good life thanks to OPM. Conversely, the bank(s) which loaned me money for my house has earned hundreds of thousands of dollars from their investment.
Time is money. Bernie Madoff burned through the money over time. If he had enough time, no one would have caught him. The financial institutions which got caught in the financial crisis simply ran out of time on their OPM. Patience is not the strong suit of most investors. The crisis was caused by people panicking on both sides of the investment/OPM equation. That’s too bad, and great investors, like Warren Buffet, will be making fat returns on the investments they are making now for many years to come.
We are in a time of imbalances. The Hopis called this Koyaanisqatsi. The golden rule of money will not change. The financial system is not out of balance, it is the same as it always was. Money does not grow on trees nor fall from heaven. The four concepts I have explained are the constants in our world. You can use them to explain any financial situation. Once you start taking apart the terms the Shamans of Wall Street come up with, you’ll see that there is just a man behind the curtain pulling levers. The question I leave leave you with is: do you want to submit to the man behind the curtain, or do you want to be the person pulling the levers?