Chapter 3 - How Money Works

Money Management

Money on its own has a few simple rules that it works by. However it has a role in every aspect of our lives. Your life can be separated into 7 categories; Spiritual, Family, Emotional, Career, Finance, Social and Physical. You have needs and wants in each of the aspects of life. When you review it you cannot deny that money is important in achieving your desires in each of these facets. Even in the Spiritual aspect of humanity, the collection plate is very important in any religion.

The proper management of money helps you in each of these aspects of life. To get the most out of your money and life, you must understand how to set life goals and then you need to understand how money works. There is a simple chart (insert link to TYM life goals URL here) you can fill out to clarify what you want in the various aspects of your life. You cannot achieve what you want and what will make you happy until you identify what will make you happy. So think about it. I have found constantly through life that once I have identified what I want the opportunities to get what I want are constantly passing by. I would have ignored these opportunities if I had not established clarity in what I wanted. I certainly missed a lot before I started setting life goals.

The capacity to take advantage of the opportunities presented for happiness are often allowed or prohibited by whether you can manage the financial aspects of the opportunity. You cannot manage money unless you know the nature of the commodity. Most of its characteristics are rather simple and predictable. The problem is that most folks just do not know how it operates to make their life work for better or for worse. The challenge is to modify your money management behavior so that it is in sync with what makes money work for you rather than against you in your achievement of your life goals.

Awareness

You have a duty to yourself and those who are close to you manage your household income competently. You need to have a viable cash flow and know what your net worth is. You need to be aware of what they are and you have to motivate yourself to use the two basic tools of a Household budget and a Household balance sheet. Use them and use them properly. If you do not fill in your budget and balance sheet properly, the first person you are lying to or letting down is you. This is a very bad idea when you are the one trying to make good decisions.

You have a duty to know the glossary of personal finance. You need to know what an asset is and what a liability is. You need to know what net worth is and what exactly it means to you. If you do not understand these terms there get help.

You have to know that you are part of something much bigger than yourself. The global economy is here and it affects you. It is something that you have little control over but it does affect everything that you do. You have to be aware that you have some measure of control even in this environment. To make good decisions you have to understand some history, politics and some economics. If you do not read books and stay current in your knowledge of the world, you put yourself at a huge disadvantage. There are only so many hours in a day. I know you cannot do everything in this complex world. However, awareness is critical to your material success. Your material success helps you to be successful in the other areas of your life.

Do what you like to do and the money will come

Part of knowing yourself and your priorities is the knowledge of what you like to do. Some people it seems are blessed with a vision of what their life is about. Interviews of successful people often include a line like, “ever since I can remember I wanted to be in movies”. Some get into a sport and it never lets them go. They eat, sleep, drink and breathe it every moment of every day. Because they love what they do so much, they naturally excel at it and are willing to do whatever it takes to be successful at it. Others see themselves in a career as a policeman or a fireman and they do whatever they have to do to make that dream come true. It may not be huge income or fame but it means they will have steady cash flow to build wealth and security to enrich their lives.

The capacity to enjoy a job may come from the fact that a family may have a tradition in such a career. A family business is often passed from generation to generation. This may be due to liking what they do or the situation being so comfortable that it makes making income easy. Some love to be near their families. Others like to be in a certain environment. Some like a different schedules. There are day people and there are night people. There are people who will work outdoors in any kind of weather rather than be stuck indoors.

Money takes time to work. To give money time to work for you, you need to have a stable cash flow. To do this you have to be able to go to work consistently and have an attitude that makes people come back and want to work with you. If you like where you are and whom you are with and what you are doing, this is easy and sustainable. When people complain about their jobs, often they are confronted with the solution of, “Why don’t you quit and do something else so we don’t have to listen to your negative attitude?” It is a valid question.

If you are happy and constantly employed at what you like to do, you can take on a mortgage and loans that will help you build your life because your banker knows that you will able to pay him back. By being consistent you qualify for lower interest rates on your debt. You are able to build savings such as retirement plans where you are able to leave them and let the miracle of compound interest work for you. You are able to plan a budget and stick to it. You will have the consistent and constant cash flow to manage to execute all of these plans.

Know where your money comes from and where it goes to

In its simplest form Accountancy is keeping an accurate record of economic activity. By tracking money we can monitor and adjust our survival strategies within our lives. To make good decisions, you must always know the facts. You must know the facts of how much money you have coming in and how much money you have going out. You need to know who is paying you how much and when. You need to know how much tax you have to pay. You must know how much you need to spend on food, shelter and clothing each month. You need to have some money for some fun. You must account for religious tithing or however you put money back into your society. To have financial success, more money must come in than is going out.

You have to have a budget. It is important that your budget be a workable budget. If more money is going out than is coming in, you have to do something to make your budget balance. Either you have to find some way to get more money to come into the budget or you have to cut spending in the areas that you can control. Some people control their budget fanatically. You will usually find that these people are quite successful. At the other extreme there are those who know nothing of budgets or deny that they have anything to contribute to life. There are those who just can’t control themselves enough to build or stay within a budget. These are usually people who are constantly in a financial struggle to stay solvent. There is the dream of making more money than you can possibly spend. In all cases, you can always spend more than you earn.

I am not saying be a fanatic and account for every last penny. However the bare minimum is that you need to be prudent to the point that you have a very clear picture of whether you are saving cash or overspending and if you are gaining wealth or losing it on a daily, monthly and annual time frame.

Plan

I believe the human capacity to plan is a defining characteristic of humans. We can make very complex plans. We can construct these plans so that they evolve over time. There are construction plans and business plans and every other kind of plot and plan you can imagine.

So plan your life. You can make 1 year, 10 year and lifetime goals in each of the 7 facets of your life. It takes time to do it. It is a process so you do it over and over again. It is the same with your household finances. You have a reality budget and balance sheet and you have your forward looking budgets and balance sheets.

As you grow your plans will grow as well. You see new horizons when you have achieved goals that you have already set. There is the old saying “Life is what happens to you while you are in the midst of making plans”. Plans are adaptations to changes in your life. Your life plan, budgets and balance sheets can always be revised. There is something wrong if you are not revising them every few months or at least annually.

The Miracle of Compound Interest

When you save, each year you leave your savings in the instrument you have chosen, you get interest paid on the interest earned in that year and the years before. There are charts to show you how this works. There are special calculators to show you the power of compound interest. It is amazing to see and it is even more amazing to put it to work for you. What is amazing is how few people put this to work for them. This is the first wealth building instrument that you should use. It is just too simple and too effective to have any glamour attached to it. I think many people miss it for just that reason. It has no bragging rights. It doesn’t shine. The one thing about it is that you will not achieve financial security without using some form of it.

The combination of the miracle of compound interest and time is amazing. Just do the simple exercise of assuming that you will get a 4% return on your money for 25 years.

  • 10 years: Get out your calculator and hit 1.04 times whatever you get from the previous multiplication and do that 10 times. The result should be 1.54 times the first result.

  • 20 years: Do this 10 more time and you will find that the result is 2.37 times the amount you started with.

  • 25 years: In the next 5 years after that you gain another 53% virtually the same result you had in the first 10 years.

So the first 10 years you gain 54%. In the second 10 years you gain 83%. In the final 25 years you gain another 53% for a total of 290% increase in value. And that is assuming only a 4 % increases compounded. Usually rates are much higher for long term investments.

This is without adding any money to the principle on an ongoing basis. The number one point here is to start savings and get to it early in life. You could flip burgers for a job and retire comfortably as long as you always saved a percentage of your income and locked it in a tax-protected instrument making compound interest. Instead of indulging the impatience of youth, get your youth to work for you. You will thank yourself when you want to be free of the yoke of a job and the economic subjectivity that it entails in your fifties and sixties. It is not exciting. It is showy though in that you are the person who gets to retire when you choose.

A mortgage compounds your savings in that with each payment, you pay interest on a smaller principal so you pay a larger amount against the total amount you owe with each payment. Equity in your home is like a savings account . The more you pay on the principal, the more savings you have. With each payment, you compound the amount of equity you put into your house with the next payment. A house is also interesting in that in most cases, the value of a house increases over time. This also compounds over time. When they say house prices increased by X% this year, they are just comparing it to last year. The house value for last year includes every value increase for all previous years. Therefore, your savings in the form of equity is compounded.

In the case of debt you see that compounding can be a double-edged sword. If you get into debt and do not even pay the interest on it, you are now paying out compound interest. If you get into debt and you have to use debt to pay off your debt the interest rates you pay on debt is very much higher than those paid on savings. So not only are your finances going the wrong way but also they are going there in a hurry.

So if you want money to work for you find some way to save money and have the interest on it compounded. Avoid debt that uses the same principle to bury you under a mountain of debt. Use the positive power of compound interest to help you work your personal finances to achieve your life goals instead of keeping you from them.

Things take time

Especially in the case of money, things take time. Mortgages are usually amortized over 20 to 30 years. New car loans are usually amortized over 5 years. New businesses are usually expected to take at least 2 years before they become profitable. Careers historically have been as long as 35 to 45 years. Life expectancy is 80 years and increasing so whatever you want to do, you have time to do it in. Use this fact to your advantage. A lot of financial plans have a starting point that is usually an investment decision followed by a long period of letting your money do the work for you. Money takes its time but it is very powerful over the long term.

The Grand Canyon is an image I have used to keep myself on course. It was created by the Colorado River working its way to the sea over millions of years. This natural wonder is an amazing example of what constant force over time can do.

Cash flow is like the flow of the water in the river. With consistency, things start to change slowly. It is hardly noticeable. However, over years and decades, the results are very measurable. You keep making more and more of an impact on that mortgage each year you pay it down until finally you get to celebrate that you are making your last payment. Over generations, some families have created wonders. Nature has its miracles like the Grand Canyon. Money and time have little miracles of their own.

Execute

In real estate location is everything. Until recently I always thought that timing was everything. Now I know that execution is everything. Every business is an example of success or failure at execution. Why are executive called executives? The boards of directors choose and review plans. Executives are in charge of executing the board of directors’ plans. Their performance is judged by how well they turn these plans into success.

So often we see youthful successes give way to some folly in mid life that undoes all the wealth and personal growth that a person has achieved to that point. So often, people will engage in highs and lows of success and failure over and over again. They have the capacity to execute but have some Achilles heal that takes them down. Some seem to be set for life and then take it all apart with some foolish act.

The effect of mistakes is to break up, halt or undo the power that time has on money. Mistakes usually mean that you have lost some money. This usually means that you have to take longer to pay off the house or that you have to use the savings that it took years to accumulate to pay for a costly mistake. You have taken two steps forward and one step back. Hopefully it is only one step back. Some mistakes take you right back to the beginning usually referred to as square one. The big penalty is that you have lost the time for the compound interest dynamic to work for you.

The dynamics are as varied as there are people. To execute for personal success is not a formula. It is impossible to make it simple. Part II of this book is an attempt to describe the positive and negative dynamics of creating your own financial security. A lot is what not to do. A lot is just common sense. How to make choices and how to make up for a bad choice is discussed. It is about helping you make the correct choices and then give you an arsenal of personal and financial tools and references to help you grow. You will need to constantly evaluate where you are in your life, where you are going and how you are going to get there. You will realize that it will never stop changing and you will never stop having to re-evaluate your life and your finances. You will learn how to review your own personal finances, make plans and then execute them with good judgment that you have learned from previous experiences.