Money and Investments - Part 3

Let’s have another look at money; how to count it and how to make it.

If we start from the point that money is a servant, then the next move is to monetise that statement.

I dont get a salary. The last time I did was from teaching at the University of Westminster in London. I was paid a little over £31 an hour. At the other end of the spectrum is someone earning £9 an hour. That is quite some difference. On the other hand rather a lot of people earn considerably more than I was earning thirty years ago. But what is the earning power of money?

The standard way to look at that is to check current interest rates. Credit card debt racks up a 27% interest rate, whereas government debt is usually defined by the central bank rate which in several western countries is hovering around the 5% mark.

There are two important ways to look at this. First is the simple calculation using what we could call the standard opportunity cost of money, say 5%. Any money earned by the use of money has to start at a figure in excess of that 5%.

The second way to look at this situation is to factor in inflation, which is usually not inflation at all, but a fall in the value of the currency, which is most definitely not the same thing.

This second figure is difficult to compute, but has very little to do with the official government figure. I dont know where you get the right figure but it is certainly (in the UK) a lot more than the official figure of 2.1%.

As I pointed out in the first of these blogs on money and real estate, there is no such thing as a magic percentage that you should aim for in your returns on investment. Life doesn’t work like that.

First problem: the official figures are very rarely correct.

Second problem: figures take on differing meanings dependant upon the criteria you set up for your ideal return, so how do you ever know whether you are choosing the right set of figures?

Let’s say you start by assuming that a 10% return on investment is acceptable.

Now let’s say you want to send your money out to work for you. How do you know you are really getting a proper wage for your money’s work?

Let’s do a simple sum, purely to show you what I mean.

I may have money in my pocket, or I may have to borrow it. That means right at the outset I need to offer you two sets of figures.

Let’s say you already have £100,000 available to use.

You want to get a minimum of 10% return on that capital.

The borrowing rate is 5%. In this instance that doesn’t concern us because we aren’t borrowing.

The inflation rate (loss of purchasing power) is running at 3%.

How are you doing?

You invest £100,000 seeking to get an annual return of 10%, so at the end of a year you should have £110,000.

The value of that £110,000 after inflation is £107,000, so in reality your 10% return only equals 7%.

If you borrow the money, the return is even worse. Here’s the sum:

110,000 - 3,000 - 5,000 = 102,000. You’ve made a grand total of 2%. Pretty pathetic!

Let’s pinch a quote from the old school report: “Could do better!”

Once you start to look at things from the point of view of your investment itself rather than some notional ideal return, things get much more complex.

If you invest in a standard, old fashioned company like Coca Cola, or Johnson & Johnson, you can check the return on your investment. On the day you choose to invest maybe that return is 3%. But 3% of what?

Let’s do the same sum we did above using the same initial investment amount.

100,000 + 3% - 3% = 100,000. That’s the original investment amount + 3% dividend - 3% loss of purchasing power.

Now let’s have a different way of calculating the return.

You look up the price of the shares you intend buying. Let us helpfully assume the price is £100 a share. If you buy the shares and check your financial position a year later you have not made a profit but you have at least made sure your funds have kept pace with inflation.

Now let’s have a look at this situation over the longer term.

Suppose the state of the nation is pretty average when you buy. You can expect your investment to compensate for the failure of the currency to hold its value, but not much more.

Supposing everything was going well and prices were rising, and the cost of your intended shares was going up quite nicely, so you bought.

A year later there is a bit of a hiccup in the economy and prices have stabilised and maybe even dropped a little. Your shares are now worth £103,000, and you have, courtesy of the dividend, managed to get a dividend payment of £3,000. You are ahead of the game. The dividend has compensated for the fall in the value of the currency.

Let us now assume there is an economic crash and your shares have lost value. You are now no longer covered by the dividend, and you are starting to lose money. This is not the way a good investment should develop.

Let’s follow this scenario a little further.

There’s a market crash. Everyone is scrambling to sell to preserve some of the invested capital.

Now let’s go back to the beginning.

There has been a market crash. That means no-one wants anything to do with the market. The general mood is that markets are dangerous places. Your average investor decides to park cash in the bank instead, and get an assured 1%. Unfortunately, because of the state of the economy, the value of money is crashing, and inflation is coming in at 8%. Your investment is now losing 7% a year (1% interest - 8% loss in the value of the currency).

Oh dear!!

However, you have been doing some research, and have noted that some people who clearly must be idiots claim that you really make your money when you buy.

How absurd can you get?

You keep your money in the bank for safety.

However, your next door neighbour, who is clearly clean off his head invests in the stock market when all is doom and gloom.

Interestingly, your neighbour can now pick up those shares you bought at £100 for the knock-down price of £50. He must be mad.

Oddly, because the price has halved, but the company is still doing business, it has maintained its dividend, which is now 6%.

Pardon?

Yes. One share equalled a dividend of 3% when the share price was £100. The dividend has been maintained so your £100 will now buy two shares, so you get two lots of 3%. Magically that comes to 6%.

Since your neighbour bought after the crash, he can now look forward to the share price regaining lost ground, so he not only collects an increased annual dividend, but also benefits from the rising share price.

Your neighbour is making his money because he bought wisely. Buy good companies when their price crashes. As your neighbour’s wife would tell you (if you’d care to listen) the sales are on, and she just happened to remind her husband of that rather enticing fact.

Next week let’s look at how the above works with regard to real estate.