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Assets
If you think that first step, saving money, is difficult, the second step, investing, is actually more than twice as hard. However, when you get to the second step of the money problem, you should congratulate yourself. Because you have solved the first problem of money of not having enough money for your needs, now you’re onto the second problem of figuring out what to do with the extra money for your immediate needs.
Obviously you can’t begin to invest your hard-earned money, if you don’t know how much you have and what you currently own. To figure out your networth, you should inventory and categorize everything that you own. Here is the table for my networth:
[table for my networth]
Notice that the sum comes out to be 100%, which is my networth. Some people make a pie chart for their assets, which is a little misleading. The pie chart cannot show negative percentages for your liability. You can have very little networth, while having both a lot of assets and liability. In accounting terms, the amount of liability over your networth (which is called equity), or the debt/equity ratio indicates your ability to borrow money. Your financial leverage is directly proportional to the amount of assets over your networth. This leverage is a dual edged sword, and it can either help you or hurt you. I have reserved the details in another section if you are interested.
So the question comes why is investing important to your wealth? There are two reasons: 1. The power of compounding. 2. Inflation. Everyone knows the power of compounding. It’s the time value of the money available today. Compounding for positive returns in time the same money will worth a lot more in the future years. But it’s a lot easier to understand this than actually getting a consistently compounded return. In fact, there are many smart people spending their every second on Wall Street and other financial markets, constantly trying to figure out how to get more money out of existing money. I will continue in why investing, and leave how to invest in another section (Efficient market & frontier).
The second reason that you should invest is because of inflation. Ever since the world comes off the gold standard, we are faced with ever growing and diluting supply of paper money. If inflation rate is zero, then there is no urgent need to invest. Since the creation of the US Federal Reserve System in 1913, $US purchasing power has been diluted by more than 95% ($1 in 1913 can buy $20.45 in 2006). It means that if your compounded annualized return of investment is not more than 3.3%, you would have lost your purchasing power. I don’t know about yours, but my money market account at NetBank (bank websites) only yields 3.52% APY, barely above 3.3%, and it’s one of the highest yields in the nation. Inflation is basically an on-going robbery by governments stealing from middle and lower class people. People in lower class have no other financial resources besides their time and labor which tracks behind the general inflation trend. People in middle class have limited amount of savings to rely upon, but often cannot generate sufficient returns to combat the erosion of purchasing power by inflation. Their biggest asset is often the home that they own which fortunately tracks inflation, while at the same time, their fixed mortgage debts are debased through time and inflation. Therefore, under normal circumstances where housing price tracks general inflation, I will advise anybody to buy a home for both inflation reason and also for the amount of financial leverage that it can provide. The leverage comes in when you make just a down payment for the asset that you purchase. A 20% down payment gives you 5 times the financial leverage, and a 10% down payment gives you 10 times the financial leverage. Your return on your down payment is essentially multiplied by the amount of financial leverage that you have, whether it’s positive or negative! Therefore, under normal circumstances, since housing price always track inflation rate, and that inflation rate is pretty much guaranteed to be positive 2 to 4%, buying a home will be the single best investment that you can make, assuming that you can afford it (Again, I emphasize normal)!