According to the Cambridge English Dictionary, it is the ability to understand the basic principles of business and finance. This is a little vague and general. Let me flesh this out for you. In my opinion, to classify yourself as being financially educated or literate, you need to have a basic understanding of the following concepts:
Concept 1: Banks have no interest in educating you
The financial industry does not want you to be free or educated. Just like the medical establishment wants to keep you ill and coming back for treatment, the financial system wants you to consume like an imbecile. Through marketing and advertising, it sells you an almost unattainable lifestyle that if you reach, you simply become another one of greed`s whore. It is never enough. Banks want to keep you ignorant and coming back to buy their products. They say they want to educate you but nothing could be further from the truth. They want to sell you their rancid products with a new shiny wrap. They want to skrew you again and again, and you get to smile while they`re doing it.
Concept 2: Credit drives the economy
Economic activity is generated through the buying and selling of goods and services. Every year the total monetary value of goods and services bought and sold is known as the gross domestic product. If the gross domestic product in year 1 was 100 and then in year 2 was 109, we say that the economy grew by 9 percent. If GDP in year 2 was 100, it means that growth was zero.
Let's now imagine a cash economy. Let's assume that there are 100 dollars in circulation. I have 50 and my friend has 20 and the bank has 30. My friend sells widgets at 10 per widget. I buy 1 widget and sell that to the bank for 15. I now have 55, my friend has 30 and the bank has 15. I deposit 40 of my 55 with the bank. We are going to move that money around between the three of us and the economy is not going to grow.
The only way an economy can grow is by way of credit. The central bank needs to increase the money supply and get the cash moving through the economy by extending credit. The government will do everything possible to facilitate credit because with more growth there is more tax revenue. The government, however, knows that too much of a good thing is not good. If there is too much credit, the economy could overheat causing inflation.
The government, therefore, allows the central bank to control the cost of money through interest rates. If the central bank feels that there is too much money being printed it will increase the cost of that money. Governments, in association with the central banks, will also allow people to start their own banks to facilitate the granting of credit to take some of the pressure off the central bank. The governments will allow these banks to take money from depositors and lend that money out as credit.
This is the basic banking model. These banks make their money on the spread between what they pay the depositors and what they charge the lenders. Central banks and use interest rates to regulate the temperature of the economy. This is known as Goldilocks economics. The central bank does not want the economy to be too hot and does not want the economy to be too cold. They want the economy to be just like the oatmeal of Goldilocks- just right. If the economy gets too hot, it means there is a risk of inflation. If too cold, there is a risk of deflation.
In the old days, banks were the only source of credit. Today, that is not the case. The monopoly of banks over the credit awarding process is being challenged by technology in a trend known as fintech. The Millennial Disruption Index reports 71that % of millennials would rather go to the dentist than listen to what banks tell them. That is a monumental kick in the nuts of the banks. Millennials would rather lie flat on their backs, open their mouths, and have sharp needles and drills perforate the soft vulnerable skin tissue around their teeth than interact with their banks. You do not need to be Alan Turing (the genius that cracked the German Enigma code) to decipher the takeaway of this nugget of information. Banks suck, and technology will drive many of them out of business.
Why has traditional banking not captured the hearts and imagination of the average man? The answer is simple. In 2008, banks lost their biggest asset and which is trust. They lost the trust of their clients and technology companies moved rapidly to fill the gap with sweet sweetness. As of 2019 Facebook boasted numerous banking licenses and was experimenting with its ow cryptocurrency. Amazon was experimenting with student loans. Alibaba was running one of the largest money market funds in the world and WeChat (the Chinese version of WhatsApp) was doing 820 million wire transfers during the Chinese New Year. If you trust Facebook with photos of your newborn baby, will you not trust them to handle your finances?
Concept 3: You need to have a basic understanding of how businesses are funded
When businesses are started, they need to be funded. They need cash, they need capital and they need it fast. Without cash, the company will shrivel up and die. Companies are funded in two ways – equity and debt. This is best understood by way of a simple example. On January 1, I start a guitar restoration business where we buy old guitars, restore them to their former glory and sell them at a profit. To start, we would need cash and/or credit. My first call is to my banker, Slim Shady who is gracious enough to offer me a loan. Slim, who is a musician when he is not ripping off unsuspecting clients, understands guitars and lends me 25,000. I now have 25,000 in debt but need more. I inject 40,000 of my own money and my friend Wayne Kerr invests 20,000 for a 30 percent stake. I have the remaining 70 percent share. We now have 25,000 of debt, plus 60,000 capital resulting in total liabilities of 85,000. I can now go out and look for axes to buy and refurbish.
This is our balance sheet as of 1 January
Current assets (cash): 85,000
Equity capital: 60,000
Long-term liabilities: 25,000
In a simple formula: Total Assets = Total Equity + Total Debt
There are two key points that you need to understand from this. Firstly, if you own equity in a company, you are the owner of that company. In this small guitar restoration business, I own 70 percent of the business and Wayne Kerr owns 30 percent of the business. The owners participate in the fortunes of the business. Secondly, the bank is simply a lender of money – it is not an owner of the business. Loans are also known as debt and liabilities.
Concept 4: You need to have a very rough understanding of the stock market
The stock market is one of the greatest generators of wealth on the face of the earth and the more you know about it, the better. Having said this, you do not need to be an expert in stocks to become financially free – a basic understanding will suffice. This is what you need to know. The stock market is a place where you can invest in thousands of public companies. In the world of finance, you have two different kinds of companies – private companies and public companies. My guitar restoration business is a private company because it is funded by myself, Wayne Kerr, and anyone else that we invite to invest in the business. At what moment does a private company become a public company? Normally, as companies grow, they need access to more money to fund their expansion. They have two options – either ask for more loans from their bank or find new shareholders to invest equity capital. Assume that Wayne Kerr is my only friend and my only source of funding. I could decide to list the company on the stock exchange and invite anyone to invest in my company. For this to happen, I need to make my financial information public and update it regularly so that my investors are kept abreast of how. The stock market provides you the opportunity of investing in thousands of companies and sharing in the fortunes of these companies. To understand the wealth-generative capabilities of the stock market, consider the following examples: If you had invested $1,000 in Amazon when it was listed on the stock market in 1997, it would be worth almost $1.6 million today (May 2020).
Concept 5: Know How to Buy the Whole Market
Not everyone was lucky enough to recognize Amazon as the next greatest thing back in 1997. You do not need to be a great visionary to make money from the stock market. You do not need to be a genius. Sure, it helps if you are prepared to spend the time to analyze individual companies, but the majority of people do not have the time, interest, or inclination to do so. For these investors, their investment vehicle of choice is known as an ETF or exchange-traded fund.
An exchange-traded fund is a fund of shares that trade on the stock market like a single share. So instead of buying a share in Amazon, you can buy a share in an ETF that invests in technology companies. In this way, you will be investing in Amazon, but also in companies like Microsoft, Apple, Tesla, Google, Facebook, Tesla, and Nvidia. I am talking about the Invesco QQQ ETF.
So this is what you do – you apply a common-sense approach to investing. I walk you through the mechanics. I will profile three different types of investors based on their level of interest in the stock market.
Investor 1: No Interest
Let us assume you have no interest in finance, business, or investing. This is not a death blow to financial freedom. You will want to invest in a broad country or global ETF. The most globally diversified ETF is iShares MSCI World ETF and trades under the ticker symbol URTH (Jargon buster: A ticker symbol or stock symbol is an abbreviation used to uniquely identify publicly traded shares of a particular stock on a particular stock market. A stock symbol may consist of letters, numbers, or a combination of both. "Ticker symbol" refers to the symbols that were printed on the ticker tape of a ticker tape machine). URTH will expose you to a broad range of developed market companies around the world. It provides access to the developed world in a single fund. If you had invested $100 every month into this ETF when it was first launched in 2012, your investment would be worth a little under $15,000 today (June 2020).
Investor 2: A Little Interest
Here I assume that you have a marginal interest in finance and the stock market. You know that CNBC is a business news channel and not a recreational drug, you have heard of the Dow Jones Industrial Average and you know that the FTSE 100 is the benchmark index of the London Stock Exchange and not a pesticide. You would invest in a more specific ETF. Instead of buying the whole world, you would refine your investment in a specific region or country. For example, you may be a fan of Taiwan. You traveled there a couple of years ago and were impressed by their bustling economy and you want to participate in the fortunes of Taiwanese companies. You could invest in the iShares MSCI Taiwan ETF (ticker symbol EWT) that trades on the New York Stock Exchange. Another great feature of ETFs is that most of them trade on US stock markets. In the case of Taiwan, there is no need for you to open a brokerage account in Taiwan – you can participate in the fortunes of Taiwanese business from the comfort of your own home (provided you have a US brokerage account). Over the past 10 years, $100 invested every month in this ETF would now (June 2020) be worth almost $19,000.
Investor 3: Above Average Interest
You have a real interest in investing as a hobby. You are curious about financial trends that are shaping the world. You are an avid reader of financial blogs and if you were waiting for your dentist appointment, you would rather thumb through a copy of The Economist than Men’s Health. Your interest does not go so far as to take you into analyzing specific shares, but you are interested in trends – such as clean and renewable energy, the rise of China as a global economic power, the sharing economy, fintech, and cryptocurrencies, the future of health and wellness, robotics and artificial intelligence, driverless cars, cybersecurity, etc. ETF issuers such as iShares are aware of the rising interest in global trend investing and have started to launch ETFs to tap into this market. Take for example the iShares Exponential Technologies ETF (ticker symbol XT). This ETF seeks to track the investment results of an index composed of developed and emerging market companies that create or use exponential technologies. The ETF wants to access global companies with significant exposure to exponential technologies, which displace older technologies, create new markets, and have the potential to create significant positive economic benefits. As of June 2020, the ETFs biggest holdings were in the following companies: TESLA, ADYEN, SQUARE, ADVANCED MICRO DEVICES MERCADOLIBRE, NVIDIA CORP, PAYPAL HOLDINGS, WUXI BIOLOGICS, AMAZON, and MEDIATEK. A monthly investment of $100 in this ETF would currently (to June 2020) be worth almost $8,500.
Concept 6: Know How to Choose a Stockbroker
In the old days, stockbroking moved at a different pace. You would park your Rolls Royce and take the elevator to your broker's office. He would open up a box of Cubans, offer you a glass of single malt, and talk about the World Series. You would instruct him to buy 1,000 shares of Bethlehem Steel. He would write the order on a ticket and hand it to his errand boy. The errand boy would jump on his bike and pedal over to the stock exchange. He would walk over to the floor broker who would ignore the kid for five minutes as he finished dictating his lunch order to his assistant. The floor broker would then saunter over to the pit and gesticulate to the market maker and execute the order. Today, the barriers to entry into the stock market are low. Any mammal with opposable thumbs, a smartphone, and a few dollars to its name can open an online brokerage account with Robinhood. Robinhood is a U.S.-based financial services company headquartered in Menlo Park, California, and requires no minimum balance. The address of Robinhood is revealing. This is not a regular broker filled with stuffy old men in pinstriped suits, Gordon Gekko suspenders, and unmatched dayglow socks with a copy of the Financial Times tucked under their flabby untoned arms. Robinhood is a fintech company, filled with kids in hoodies, looking to democratize the stock market.
Most discount brokers offer commission-free trading and zero minimum deposit (they make money off your cash balances and margin lending). The top dogs are Fidelity, TD Ameritrade, TradeStation, Charles Schwab, E*TRADE, and Interactive Brokers. In choosing a broker, you want to look at the following: quality of order execution, depth of research, technological quality of their platform, trading tools offered, customer service, non-trading fees (wire and bank transfers), availability of options trading and margin rates (where brokers make most of their money).
Concept 7: Understand the Most Important Concept in Finance – Compounding
The world is full of wonders. You have the Great Pyramids of Giza, the Hanging Gardens of Babylon, the Lighthouse of Alexandria, the Temple of Artemis, and the Colossus of Rhodes.
In finance, there is one single wonder that stands out head and shoulders above the rest – and that is COMPOUNDING. The reason why the majority of humans are not aware of this modern wonder is that it is built on a trait that most humans do not have – PATIENCE. Post a video on Youtube entitled “How to Become a Millionaire in 30 Years”. How many views do you think it will get? I would wager that a video of a dripping tap would get more views.
We are impatient. Everyone wants to get rich quickly. The reality is that getting rich requires compounding and patience. Let me explain. If investing $100 per month at a return of 10 percent will deliver $226,048, how much would I have if I found an investment that yields 20 percent? The human brain in all its feebleness would reason like this – if I am earning double the return (20 percent instead of 10 percent), it should earn double the return. In other words, I should be the proud owner of an investment worth $450,000. What would you say if I said that by doubling the annualized return you would earn TEN times more? You would say that I have gone bonkers – that I have donned a bright red honker and size 75 loafers, and am bouncing jelly beans off my belly and pulled live pigeons out of my ear. Your $100 investment at 20 percent per annum will yield $2,297,783 in 30 years!!
Albert Einstein said that compound interest is "the most powerful force in the universe" and went on to say..." he who understands it, earns it; he who doesn't, pays it." The reason you earn 10 times more with twice the return over 30 years is simply that you are reinvesting your returns. You are earning returns on your returns. This may sound like Greek, but let me explain with a simple example. You invest $100 on day 1 at 20 percent. In one year, that $100 has grown into $120 which means you made a $20 return. In year 2, again you earn 20%, but on $120. This means that you made $24 which is 24 percent of the original $100 invested. Look at how the returns take off the longer you invest.
Year 1: $20 (20 percent on $100)
Year 2: $24 (24 percent on $100)
Year 3: $28.8 (28.8 percent on $100) …….
Year 10: $103 (103 percent on $100) …….
Year 20: $638 (638 percent on $100 …….
Year 30: $3,956 (3,956 percent on $100)
By year 30, you are earning an astronomical return on you’re your initial $100 because the investment has snowballed as you reinvest your returns.