The best investment you’ll likely ever make is in yourself.
One way to look at the economy is as the sum of millions of transactions. And while we have
to be careful about extrapolating the microeconomic aspects of these transactions to the larger context, exploring microeconomic transactions in more detail can be helpful in understanding how these seemingly individual acts influence the broader economy. In this chapter I cover some basic specific aspects of the underpinnings of the macroeconomic machine.
At the most basic level the monetary system is made up of spending, which creates someone else’s income. For simplicity I’ll break down the income component of this concept. There are three basic things you can do with your income. You can consume, invest, or save. Let me be more specific.
We obtain money in part because we need to use it to accommodate our current or future needs. Most of our income goes into consumption, accommodating our current needs. Consumption is the final sale of goods and services. You consume things like housing, food, or a new TV.
Consumption—the final sale of goods and services
You could also use your income to produce more in the future. Production is the creation of value by turning out goods and services. Production and consumption are two sides of the same coin: producers ultimately require consumers to purchase output (producers need consumers). When we spend in order to produce, we are making an investment.
Using the word investment requires precision because it generally is associated with the purchase of something like a share of stock on the New York Stock Exchange. But that’s not always accurate. Investment is actually spending, not consumed, for future production. Say that a bunch of times so it sinks in. Investment is spending not consumed for future production. Examples include building a factory or going to college. You’re making an investment in something in the hope that it will generate future production.
Investment—spending not consumed for future production
You can use your income in a third way, too. You can do nothing with it. This is called saving. Saving is simply income not consumed.
Saving—income not consumed
When you save, you’re not really doing nothing with your savings. In a monetary world you are by definition allocating your savings to some financial instrument. Many of us simply keep our savings in a bank account, where it is held as bank deposits that earn no interest but are available to be tapped when we want or need to consume. Technically all income is saved, at least for a brief moment, before it is used for consumption or investment.
In a monetary world you have options for saving your income if you should choose to do. You can allocate your savings however you like. You might move your savings into a savings account, where it earns a little interest. You might allocate it to something a bit more risky, such as a government bond. Or you might allocate it to stocks, corporate bonds, real assets, or other monetary vehicles that allocate your savings for you (for example, exchanged traded funds or mutual funds). These are all ways of allocating your savings. But I don’t want you to always think of this as investment as it is traditionally portrayed in the media. Let me explain why.
Most of us think of investment in the stock market sense. Most of us think we invest in stocks and bonds. But we are not actually investors in the purest sense of the word when we buy stocks and bonds. Most of us are simply savers who allocate our assets to certain financial instruments. To understand this point it is necessary to understand exactly why these financial instruments exist. When a new corporation is formed, it might raise money in a number of different ways. The most traditional form is a simple bank loan or the issuance of corporate debt. But it could also raise money by selling equity, or ownership, in the company. When someone provides funding for a corporation in this manner, it will issue them the equivalent of a stock certificate, which gives the investor a legal claim on a certain ownership portion of the business. In making this investment the investor has provided the corporation with current capital that will help it create future production.
The investor has made a real investment in the company. Remember: Investment is spending not consumed for future production. The investor in this example has spent but not consumed in order to fund the future production of the firm.
Now, what if that initial investor no longer wants to own that stock certificate and sells it to a neighbor, Sue, who thinks the company is a good value? In this case Sue will exchange cash for the stock certificate, which results in a change in ownership of the
stock certificate. When Sue buys shares in this manner, she is allocating savings. The buyer is not an investor in the same sense that the initial investor was because the underlying company has no real involvement in the transaction. This purchase of stock does not actually fund future production of the company. It simply changes the legal ownership of the outstanding stock from one person to another. An exchange or reallocation of savings has occurred, but no funding of future production has occurred.
UNDERSTANDING SECONDARY MARKETS AND PRIMARY MARKETS
This brings me to the concept of secondary markets and primary markets. Shares of stock, like the one I just discussed, are issued in a primary market in which real investors provide funding to a corporation in exchange for shares. Primary markets provide funding for future production. They are more widely known as the place where an initial public offering (IPO) occurs. An IPO provides funding for a corporation, but as soon as the shares are issued, they will trade on a secondary market, in which buyers and sellers exchange them. The New York Stock Exchange is so called because it is where buyers and sellers meet to exchange ownership of shares. When you buy a share of stock, you are obtaining someone else’s stock, and someone else obtaining your cash in exchange.
Buyers and sellers are exchanging ownership of assets by allocating their savings to specific instruments. You can think of primary markets as the place where investment is made to provide firms with capital for future production, and you can think of secondary markets as the place where savers reallocate their savings by exchanging financial assets.
A SIMPLE CONSUMPTION, PRODUCTION, AND SAVING SYSTEM
Let me give you a real-world example to illustrate how the pieces of the puzzle work here. First I’ll explain exactly how a firm goes about
operating—how it produces goods and services, how its consumers consume, how the business generates a profit, how it grows, and how others can benefit from either investing in the corporation or allocating their savings to it.
Step 1—Starting a company. My friends and I are creating a corporation that hopes to produce computers. So we file regulatory documents, name the corporation (call it MacroSoft), and start operating out of my garage. We have great ideas for designing the software and hardware for these computers (we’ll just copy the hardware design from the
Granny Smith Corporation), but we don’t have the capital to begin building the computers. So we need to raise capital.
Step 2—Raising capital. Assume we have $10,000 that we’ve invested in the company ourselves, but we think it will take $20,000 to build the first few computers to sell and comfortably manage the first year of operations. So we need to convince someone else to give us $10,000 more.
We could raise capital in a number of different ways. The most common way is to obtain a bank loan. But banks don’t generally like to loan money to a new company with no revenues and no collateral, so we will look elsewhere. We’ll start by selling corporate debt to private investors. We convince our friend Gill Bates to provide $2,500 at a rate of 10 percent ($250) interest per year for one year. But we’re still $7,500 short of our capital-raising goal. We are worried we can’t afford the interest payments on $7,500 more in corporate debt, so we decide to sell part of the company. We decide to raise money by selling equity in the firm, and someone named Allen Paul agrees to provide
$7,500 in exchange for 37.5 percent of the company. This is a less risky way to raise capital now (because the 10 percent interest rate is expensive) but could turn out to be a more expensive option if our company is wildly successful (because that 37.5 percent ownership is an ownership share we are foregoing). So, now we have our $20,000 in cash as well as $20,000 in outstanding securities ($2,500 in corporate debt and $17,500 in private stock—we still own 62.5 percent of the company, but that’s not important for now).
Step 3—Understanding our corporate balance sheet. Because money is a record of account (see chapter 1), my friends and I will have to understand basic accounting in order to understand how money works. A sound understanding of modern money requires a basic understanding of accounting.
From here we can begin to see what our corporation looks like on paper before it has actually produced anything. A simple balance sheet shows our assets, liabilities, and net worth, as shown in Figure 3.1.
Figure 3.1: MacroSoft Balance Sheet—Raising Money
Assets–liabilities = net worth (shareholders’ equity). That’s simple, right? Balance sheets must balance. Our simple balance sheet shows total assets of $20,000 in cash,
$2,500 in corporate debt, and $17,500 in shareholders’ equity (which includes our initial
$10,000 investment in addition to Allen Paul’s $7,500 investment). Shareholders’ equity, another term for net worth, is the shareholders’ claims on the company’s assets. If we sell the business today and pay off all creditors, the shareholders’ equity is what would be left over.
Step 4—Starting operations. To start operations we need to invest in any supplies that will go into the production process. Say we purchase a production line for $1,000 and install it in my garage. This is a fixed asset for our business. We also need any supplies that will go into the actual production of the computers. Say these supplies cost $5,000.
After all these investments our balance sheet looks like Figure 3.2.
Figure 3.2: MacroSoft Balance Sheet—Starting Operations
Step 5—Generating income and understanding the income statement. We make some simple assumptions about how our business operates in year one. We produce and sell 20 computers at a price of $2,000 each, and each computer costs us
$250 to make. We have no employees other than ourselves, so we’re building the computers, and only our labor goes into developing the final product. Being an entrepreneur isn’t always easy.
Now we can look at another important accounting statement, our income statement, which shows the revenues, costs, and profits for our business in the current period (see Figure 3.3).
Figure 3.3: MacroSoft Income Statement
We have revenues of $40,000 from selling 20 units at $2,000 each. We also have
$5,000 in expenses from the cost of production ($250 for each of 20 units) and interest expense of $250 (don’t forget the debt we sold to fund the company). So we have pretax earnings of $34,750 after year one. Nothing too complex here so far, but I’ve covered a
lot of the basics. We’ve invested in our future production, we’ve raised capital from outside investors, we’ve produced goods (supply), and we’ve seen how our consumers (demand) are essential to our success. Now it’s time to look for the exit strategy from this successful business.
Stage 6—Selling on the secondary market. At this point we’ve had a pretty good run with our business. We’ve been around for only one year, but we’ve created a product that generated a profit, helped people enhance their lives, and made the owners of the company better off. So let’s cash out. If we look at our balance sheet now, it looks like Figure 3.4.
Figure 3.4: MacroSoft Balance Sheet—One Year Later
Remember, we began with $20,000 in cash and invested $6,000 in the production line and supplies to build our computers. Those supplies went out the door in the final product, but the fixed asset in the production line remains part of the business (ignore depreciation for now since that just muddies things). So we now have $14,000 in cash ($20,000–$6,000) plus the $1,000 production line minus the interest expense of $250 paid to our bond investor plus the final annual revenue of $40,000. So our balance sheet after year one shows $53,750 in cash, $1,000 in fixed assets, $2,500 in corporate debt, retained earnings of $34,750, and our original capital stock of $17,500. This leaves us with total assets of $54,750, liabilities of $2,500, and, once we pay back our corporate debt, shareholders’ equity of $52,250 (assets–liabilities = net worth). In other words, if we sold the whole business today and paid back our debtors, the shareholders would get
$52,250 to divide among themselves. Not bad.
In order to cash out we might sell our shares to someone else in a secondary market.
In doing so we would simply be exchanging the existing ownership claim in the business for money from whomever becomes the new owner. The new owner, however, is not injecting new capital into the firm. The new owner, Tony, is simply reallocating his cash into the stock of this company, and we are reallocating our stock into cash. We’ve exchanged stock for cash, and Tony has exchanged cash for stock. Tony is not an investor in the traditional sense of the word. He is merely allocating his savings. It’s that simple.
Before I conclude here, I want to revisit an earlier discussion. Remember when my
friends and I sold the corporate debt and the equity to fund the firm? We sold 37.5 percent of the company to an equity investor because we were worried that the debt might be too expensive. That debt ended up costing us $250 during the one year. But when we sold the company, we paid out 37.5 percent to our equity owner. That means 37.5 percent could have gone to us if we’d been willing to sell more corporate debt. In other words, the equity cost the founders quite a bit of money.
This simple business shows how investment works (spending to generate future production) and how consumption works (someone had to buy the computers). It also illustrates the workings of a primary market, whereby some investors seeded capital to help us start our company. And the business demonstrates how a secondary market works: the ownership of the business changed hands, and a reallocation of savings occurred.
SAVER OR INVESTOR? WHICH ONE ARE YOU?
When confronting the world of money and how you will participate in the economy, nothing is more important than understanding when you are an investor, when you are a saver, or when you are both. Remember: Real investors seed future production by providing capital for future production. Savers merely allocate their unconsumed income to financial assets.
When you think about your overall portfolio, you should try to think of your asset allocation in terms of this breakdown. If you are a true investor in the sense that you seed capital for the purpose of future production, you’re playing a different role than someone who is simply exchanging shares on a secondary market and allocating savings.
It’s a nuanced point but an important one that will guide your understanding of how you obtain money, how you use it, and how you protect it. Figuring out whether you’re an investor, saver, or both is how you’ll make many of your most important financial decisions.
THE BEST INVESTMENT YOU’LL EVER MAKE
Most of us go through life thinking of investing as something you do in the stock market or in other companies. We don’t always think of it as something personal. But the reality is that the best financial investment most of us will ever make is in our own future production. The key to understanding our value in a monetary system is understanding how each of us is uniquely valuable to other people. In this interconnected monetary
world we all have something that other people can find value in. And one thing you have to figure out is what that means to you. Of course it means different things to different people. We all have different talents and different specialties. The best investment you’ll ever make is in trying to understand and maximize the value you can contribute to other people.
A capitalist system is often portrayed as an individualistic and selfish construct. But I think the best capitalist systems are those built on the simple understanding that we serve ourselves best by serving others. This means that most of us will make our true investments in things like our educations, skills, training, and so on so we can provide something even more valuable to others. This is where we will spend our own capital in the hope of generating future production.
This future production will generate an income that finds its way into a repository we call our savings. From there we need to decide how we will spend that capital. Will we simply consume it all on goods and services? Will we invest it in the hope of generating future production? Or will we simply allocate it to existing assets in the hope of protecting it? Answering these questions is personal, something each of us needs to explore on our own. Some of us will choose to maximize our investment in our primary expertise while choosing to allocate our savings in a prudent and methodical manner, whereas others might choose to use their savings for purposes that more closely resemble pure investment. But remember: your income is your monetary lifeblood. So before you go thinking that the best investment you’ll ever make is in shares on a stock exchange or in instruments issued by some other entity, first consider that the best investment you’ll ever make is in yourself.
UNDERSTANDING YOUR TOTAL PORTFOLIO
By now I hope you’re beginning to see why I stress the difference between saving and investing. Investing, the pursuit of generating future production by spending your capital, can be highly rewarding but can also be dangerous in many cases because it often involves fronting our own capital for this future production.
Most of us are already making investments in ourselves over time and are generating an income stream that helps us build savings. We invest in ourselves to maximize our future production. We are experts in something in which we have made these real investments. So we have to understand how we then decide to allocate our capital in what I like to think of as a “total portfolio.” You should think of your personal balance