Perspective Matters
April is Financial Literacy Awareness Month. If you ask the internet to define financial literacy you’ll get many answers, and they all have a few things in common; a focus on budgeting, tracking your spending and spending less than you earn. While those ideas are important and key habits, that’s not what I think about when I think of financial literacy. I want you to have a basic understanding about how our economy works so you can decide how you want to participate in a way that helps you reach your personal goals and aspirations.
You’ve heard the phrases “money makes the world go around” and “follow the money” but have you ever thought about what they are really saying about people? In its simplest form, the meaning of both is that financial incentives, also known as economic incentives, are often the most powerful incentives driving most human behavior. I believe that we are all pre-disposed to be driven by either the pursuit of gains or the avoidance of losses, and the more we understand about the world around us the more likely we are to be successful in navigating it.
So, let’s start with the basics. What is money? Its most basic definition is that it is a “medium of exchange,” another way of saying that money is something we can exchange for goods or services. Before we had money or banking systems, we had groups of people that lived together, and each contributed something to the community. If your family made bread, you might exchange some with the family who made clothes instead of trying to make your own clothes. You would negotiate on how many loaves of bread you would need to provide in order to receive items of clothing. This is known as a “barter economy."
The example I used is very simplistic; the next step is to set up a system in which the goods can be made available to the community and people can acquire what they need without direct exchanges. Each item – a loaf of bread, a man’s shirt, a wagon wheel – is assigned points based on how many hours of work it took to create. Included in the calculation of hours to create would be finding the raw materials, so something made from plentiful resources would be assigned fewer points than something that required the maker to travel distances to find enough materials to make the good. Everyone who contributed something and was given points could then exchange those points for items created by other people. As you can imagine, there would be much discussion about how many points to assign to each product, and the majority would ultimately have to come to agreement for the system to work. Those points are a form of money, and you could call the number of points each item was assigned the “price.”
Obviously, this is a very simplistic example, but what should be clear is that everyone is motivated to contribute something so that they can get the points to acquire the things they need and want. In small communities this was pretty simple and clear. If someone was unable or unwilling to contribute, it would limit their access to the things they needed or wanted. Over time the idea of “trading” the things your community made for things made by another community evolved, and eventually grew into the global economy we have today. Along the way different communities developed their own forms of money, so in addition to having a “price” within one community to acquire a good or service, we developed “exchange rates” for each community’s currency.
In a capitalist economic structure, the prices of goods and services and the exchange rates between currencies are not fixed by anyone; the values are changing constantly based on both supply and demand for goods and services as well as for each currency. If I make bread and it takes me five hours to make one loaf of bread, someone who can do it in four hours can afford to charge less for their bread, right? As the consumer, you choose which bread to buy; some people will choose to buy bread based only on the lower price, while others may prefer the taste of my bread more, and think it is worth paying a higher price for it. If not enough people think my bread is worth the price, then I either have to find a way to improve my bread, lower my cost to produce it so I can lower my price, or I stop making bread altogether.
If I live in the United States and want to buy something made in another country, most of the time I will need to pay for it in that country’s currency. If I want a car built in Japan, I must sell US dollars and buy Japanese Yen. In reality, someone else – the car company or the car dealership, for example – handles the currency transaction so I use my US dollars at my local car dealer. At some point, though, someone has to exchange Dollars for Yen to get that Toyota or Lexus to my town, so that exchange rate (how many dollars buys enough yen to buy the car) affects the price I pay for that car. When one US Dollar buys more Japanese Yen today than yesterday, we say the Dollar has strengthened. When the Dollar is strong, is helps lower prices for Americans buying products made elsewhere, but it also makes the prices of American made goods more expensive for people who live in other countries. (Another example of why the first answer to most questions is “it depends!”)
In theory, markets for all goods and services, as well as markets for currencies, work like ongoing auctions; buyers are “bidding” to demonstrate the price they are willing to pay, sellers are “offering” to demonstrate the price at which they are willing to sell, and a transaction occurs when they agree. In reality markets for some goods, services and currencies work more smoothly than others, but that’s a story for another post!
Going back to the idea of the barter economy, you can see how the idea of money developed; it could be challenging to match up the timing of everybody's needs for different goods and services and the availability of those goods and services. Money allows the value of each good and service to be translated into something else – money - that can then be held until it is needed to purchase other goods and services.
Once you have the means of holding value it can be transferred to others to increase their ability to produce goods or services. If you transfer some of your money to somebody else to help them produce more goods or services, you may be guaranteed to get your money back with some predetermined extra amount or you might be given a share of the money from the additional goods and services that may be produced.
What I've just described is the foundation of investing. Saving is the behavior of setting aside some of the money you earned today so that you may use it in the future to acquire things you may want or need. Investing is allowing someone else to use some of the money you have saved to produce more goods or services. Since you are helping them produce more goods or services your investment will generate a return, meaning you could get back more money than you originally provided. You can increase your certainty by negotiating in advance how much you get back regardless of how much additional goods or services they're able to create and sell. That's a bond.
Another option is for you to get back an amount related to the goods and services sold by the other person. You would negotiate in advance what you will receive, usually as a percentage of the profit (what is left after subtracting expenses from income.) Of course, if nobody buys any of the extra goods and services there won't be any money to give you, but if many people want those goods or services and are willing to pay for them, you could get a lot more money back by taking a share of the profit instead of a predetermined fixed return. That's a stock.
Intermediaries facilitate money moving back and forth between people that have it and people that need it to run businesses. Banks for example often lend most of the money that you deposit in your bank accounts. They collect interest on the loans and pay you some of that interest while using the rest of it to cover their expenses and give profits to their shareholders. Brokers can get paid to match buyers and sellers of stocks and bonds.
Everything in our capitalist economy is built on these basic ideas. There are always people trying to come up with more creative ways to get money from people that have it to people that need it to run businesses. Most of the time these opportunities are good for everyone involved, as long as you understand what to expect.
One of the challenges that new investors often face is not understanding the language and terminology of investing. You could do simple Internet searches to get the definitions of different terms. My purpose here is to help you understand how our economy works using a very simple example. You can take the example I've outlined above and imagine how quickly it gets much more complicated to try to anticipate what kinds of goods and services people are going to want in the future and how much of those goods and services they're going to be willing to buy and of course the price that they're going to be willing to pay for those goods and services.
There are many opportunities to facilitate matching up people that produce goods and services with people that need goods and services and earn money for doing it because both buyers and sellers have an incentive to find each other more quickly. But it all comes back to the same basic ideas I’ve outlined above.
My hope is that this simple framework about how our economy works can help you navigate your own path to financial independence. As always, I encourage you to consult with a Certified Financial Planner® professional to assist you on your journey to financial security.
Neither Prism Planning and Solutions Group nor Insight Advisors provide tax advice, and nothing in this communication should be treated as such. This communication should not be interpreted as a recommendation for a specific investment or tax-planning strategy. We are providing this material for informational purposes only. We have made every attempt to verify that information contained in this communication is accurate as of the date published but make no warranties. Before making any decisions related to your own tax and/or investment situation you should consult the appropriate professionals.
Certified Financial Planner Board of Standards, Inc. (CFP Board) owns the certification marks CFP®, CERTIFIED FINANCIAL PLANNER™, and CFP® (with plaque design) in the United States, which it authorizes use of by individuals who successfully complete CFP Board’s initial and ongoing certification requirements.