2 Basic Ideas of Finance

INTRODUCTION

Money, says the proverb, makes money. When you have got a little, it is often easy to get more. The great difficulty is to get that little.

—Adam Smith, The Wealth of Nations (1776)

Personal finance addresses the “great difficulty” of getting a little money. It is about creating productive assets—that is, resources that can be used to create future economic benefit, such as increasing income, decreasing expenses, or storing wealth, as an investment, and about protecting existing and expected value in those assets. In other words, personal finance is about learning how to achieve your goals and how to protect what is important to you.

There is no trick to managing your personal finances. Making good financial decisions is largely a matter of understanding how the economy works, how money flows through it, and how other people make financial decisions. The better your understanding, the better your ability to plan, take advantage of opportunities, and avoid disappointments. Life can never be planned entirely, of course, and the best-laid plans can go awry, but anticipating risks and protecting against them can minimize your exposure to the inevitable mistakes and ups and downs of life that we all experience.

The AFOA BC equates financial literacy with financial fitness: “when you are financially fit you are able to make informed choices about finances and you understand how your choices are going to impact your wallet and your life” (AFOA BC, 2011, p. 7). Just like it takes effort to become and remain physically fit, it takes effort to become financially fit: “you have to train. You have to obtain information, knowledge and skills and apply them so you can make good choices about how you treat your money and how your money treats you” (AFOA BC, 2011, p. 7). You don’t need lots of money to be financially fit—after all, there are plenty of people with money who aren’t financially fit—but you must build your skills and knowledge base “about money, savings, spending, credit, investing, and everything else people do with money. Then you can use what you learn to make choices for you and your family that help—not hurt—your bank account” (AFOA BC, 2011, p. 8).

2.1 INCOME AND EXPENSES

Personal finance is the process of paying for or financing a life and a way of living. Just as a business must be financed—its buildings, equipment, use of labour and materials, and operating costs must be paid for—so must a person’s possessions and living expenses. Just as a business relies on its revenues from selling goods or services to finance its costs, so a person relies on income earned from selling labour or capital to finance his or her costs. You need to understand this financing process and the terms used to describe it. In the next chapter, you’ll look at how to account for it.

Where Does Income Come From?

Income is what is earned or received in a given period. There are various terms for income because there are various ways of earning income. Income from employment or self-employment is wages or salary. Deposit accounts, like savings accounts, earn interest, which could also come from lending. Owning stock entitles the shareholder to a dividend, if there is one.

The two fundamental ways of earning income in a market-based economy are by selling labour or selling capital. Selling labour means working, either for someone else or for yourself. Income comes in the form of a paycheque. Total compensation may include other benefits, such as retirement contributions, health insurance, or life insurance. Labour is sold in the labour market.

Selling capital means investing: taking excess cash and selling it or renting it to someone who needs liquidity (access to cash). Lending is renting out capital; the interest is the rent. You can lend privately by direct arrangement with a borrower, or you can lend through a public debt exchange by buying corporate, government, or government agency bonds. Investing in or buying corporate stock is an example of selling capital in exchange for a share of the company’s future value.

You can invest in many other kinds of assets, like art, land, or commodities such as soybeans, live cattle, or potash. The principle is the same: investing is renting capital or selling it for an asset that can be resold later, or that can create future income, or both. Capital is sold in the capital market and lent in the credit market—a specific part of the capital market (just like the dairy section is a specific part of the supermarket). Table 2.1.1 shows the sources of income.

Similarly, the fewer skills required for the job, the more people there will be who are able to do it, which in turn creates a buyers’ market. The more skills required for a job, the fewer people there will be to do it, and the more leverage or advantage the seller has in negotiating a price. People pursue education to make themselves more highly skilled and therefore able to compete in a sellers’ labour market.

When you are starting your career, you are usually in a buyers’ market (unless you have some unusual gift or talent), if only because of your lack of experience. As your career progresses, you have more, and perhaps more varied, experience and presumably more skills, and so can sell your labour in more of a sellers’ market. You may change careers or jobs more than once, but you would hope to be doing so to your advantage—that is, always to be gaining bargaining power in the labour market.

Many people love their work for a variety of reasons other than the pay, however, and they choose it for those rewards. Labour is more than a source of income; it can also be a source of intellectual, social, and other personal gratifications. Your labour is nevertheless a tradable commodity as well and therefore has a market value. The personal rewards of your work may ultimately determine your choices, but you should be aware of the market value of those choices as you make them.

Your ability to sell labour and earn income reflects your situation in your labour market. Earlier in your career, you can expect to earn less than you will as your career progresses. Most people would like to reach a point where they don’t have to sell labour at all. They hope to retire someday and pursue other hobbies or interests. They can retire if they have alternative sources of income—if they can earn income from savings and from selling capital.

Capital markets exist so that buyers can buy capital. Businesses always need capital and have limited ways of raising it. Sellers and lenders (investors), on the other hand, have many more choices of how to invest their excess cash in the capital and credit markets, so those markets are much more like sellers’ markets. The following are examples of ways to invest in the capital and credit markets:

• Buying stocks
• Buying government or corporate bonds
• Lending a mortgage

The market for any particular investment or asset may be a sellers’ or buyers’ market at any particular time, depending on economic conditions, if there are more sellers than buyers. Typically, however, there is as much or more demand for capital as there is supply. The more capital you have to sell, the more ways you can sell it to more kinds of buyers, and the more those buyers may be willing to pay. At first, however, for most people, selling labour is their only practical source of income.

Where Does Income Go?

Expenses are costs for items or resources that are used up or consumed in the course of daily living. Expenses recur (i.e., they happen over and over again) because food, housing, clothing, energy, and so on are used up on a daily basis.

When income is less than expenses, you have a budget deficit: too little cash to provide for your wants or needs. A budget deficit is not sustainable; it is not financially viable. The only choices are to eliminate the deficit by 1) increasing income, 2) reducing expenses, or 3) borrowing to make up the difference. Borrowing may seem like the easiest and quickest solution, but borrowing also increases expenses because it creates an additional expense: interest. Unless income can also be increased, borrowing to cover a deficit will only increase it.

A better, although usually harder, choice is to either increase income or decrease expenses. Table 2.1.2 shows the choices created by a budget deficit.

1. Depositing into a savings account at a bank
2. Contributing to a retirement account
3. Purchasing a guaranteed investment certificate
4. Purchasing a government savings bond

Table 2.1.3 shows the choices created by a budget surplus.

Opportunity Costs and Sunk Costs

Aside from expenses, there are two other important kinds of costs that affect your financial life. Suppose you can afford a new jacket or new boots, but not both, because your resources—the income you can use to buy clothing—are limited. If you buy the jacket, you cannot also buy the boots. Not getting the boots is an opportunity cost of buying the jacket; it is the cost of sacrificing your next-best choice.

In personal finance, there is always an opportunity cost. You always want to make a choice that will create more value than cost, and so you always want the opportunity cost to be less than the benefit from trade. You bought the jacket instead of the boots because you decided that having the jacket would bring more benefit than the cost of not having the boots. You believed your benefit would be greater than your opportunity cost.

In personal finance, opportunity costs affect not only consumption decisions but also financing decisions, such as whether to borrow or to pay cash. Borrowing has obvious costs, whereas paying with your own cash or savings seems costless. Using your cash does have an opportunity cost, however: you lose whatever interest you may have had on your savings, and you lose liquidity. In other words, if you need cash for something else, like a better choice or an emergency, you no longer have it and may even have to borrow it at a higher cost.

When buyers and sellers make choices, they weigh opportunity costs, and sometimes regret them, especially when the benefits from trade are disappointing. Regret can colour future choices. Sometimes regret can keep us from recognizing sunk costs.

Sunk costs are costs that have already been spent; whatever resources you traded are gone, and there is no way to recover them. Decisions, by definition, can be made only about the future, not about the past. A trade, when it’s over, is over and done, so recognizing that sunk costs are truly sunk can help you make better decisions.

For example, the money you spent on your jacket is a sunk cost. If it snows next week and you decide you really do need boots too, that money is gone and you cannot use it to buy boots. If you really want the boots, you will have to find another way to pay for them.

Unlike a price tag, opportunity cost is not obvious. You tend to focus on what you are getting in the trade rather than what you are not getting. This tendency is a cheerful aspect of human nature, but it can hamper the kind of strategic decision-making that is so essential to financial planning. Human nature may also make you focus too much on sunk costs, but all the relish or regret in the world cannot change past decisions. Learning to recognize sunk costs is an important part of making good financial decisions.

REFERENCES

Aboriginal Financial Officers Association of British Columbia. (2011). First Nations Financial Fitness: Your Guide for Getting Healthy, Wealthy and Wise. Retrieved from: http://www.afoabc.org/wp-content/uploads/2015/06/financial-literacy-handbook.pdf.

Smith, A. (1776) 2000. The Wealth of Nations, Book I, Chapter ix. New York: Modern Library.

2.2 ASSETS

As defined earlier in this chapter, an asset is any item with economic value that can be converted to cash. As such, they can be used to create income or reduce expenses and to store value. The following are examples of tangible (material) assets:

• Car
• Savings account
• Wind-up toy collection
• Shares of stock
• Forty acres of farmland
• Home

Selling excess capital in the capital markets in exchange for an asset is a way of storing wealth, and hopefully of generating income as well. The asset is your investment—a use of your liquidity. Some assets are more liquid than others. For example, you can probably sell your car more quickly than you can sell your house. As an investor, you assume that when you want your liquidity back, you can sell the asset. This assumes that it has some liquidity and market value (some use and value to someone else) and that it trades in a reasonably efficient market. Otherwise, the asset is not an investment, but merely a possession, which may bring great happiness but will not serve as a store of wealth.

Assets may be used to store wealth, create income, and reduce future expenses.

Assets Store Wealth

If the asset is worth more when it is resold than it was when it was bought, then you have earned a capital gain: the investment has not only stored wealth but also increased it. Of course, things can go the other way too: the investment can decrease in value while owned and be worth less when resold than it was when bought. In that case, you have a capital loss. The investment not only did not store wealth, it lost some. Table 2.2.1 shows how capital gains and losses are created.

The better investment asset is the one that increases in value—creates a capital gain—during the time you are storing it.

Assets Create Income

Some assets not only store wealth, but also create income. An investment in an apartment or house can potentially store wealth and create rental income, for example. An investment in a share of stock stores wealth and also perhaps creates dividend income. A deposit in a savings account stores wealth and creates interest income.

Some investors care more about increasing asset value than about income. For example, an investment in a share of corporate stock may produce a dividend, which is a share of the corporation’s profit, or the company may keep all its profit rather than pay dividends to shareholders. Reinvesting that profit in the company may help the company to increase in value. If the company increases in value, the stock increases in value too, thereby increasing investors’ wealth. Further, increases in wealth through capital gains are taxed differently than income, making capital gains more valuable than an increase in income for some investors.

On the other hand, some investors care more about receiving income from their investments. For example, retirees who no longer have employment income may be relying on investments to provide income for living expenses. Being older and having a shorter horizon, retirees may be less concerned with growing wealth than with creating income.

Assets Reduce Expenses

Some assets are used to reduce living expenses. Purchasing an asset and using it may be cheaper than arranging for an alternative. For example, buying a car to drive to work may be cheaper, in the long run, than renting one or using public transportation. The car typically will not increase in value, so it cannot be expected to be a store of wealth; its only role is to reduce future expenses.

Sometimes an asset may be expected to both store wealth and reduce future expenses. For example, buying a house to live in may be cheaper, in the long run, than renting one. In addition, real estate may appreciate in value, allowing you to realize a gain when you sell the asset. In this case, the house has effectively stored wealth. Appreciation in value, however, depends on the real estate market and demand for housing when the asset is sold, so you cannot count on such a gain. Still, a house usually can reduce living expenses and be a potential store of wealth. In some cases, a house not only reduces living expenses and potentially stores wealth, but also increases income if, for example, the basement or other spaces in the house are rented by tenants.

Table 2.2.2 shows the roles of assets in reducing expenses, increasing income, and storing wealth.

The choice of investment asset, then, depends on your belief in its ability to store and increase wealth, create income, or reduce expenses. Ideally, your assets will store and increase wealth while increasing income or reducing expenses. Otherwise, acquiring the asset will not be a productive use of liquidity. Also, in that case, the opportunity cost will be greater than the benefit from the investment, since there are many assets to choose from.

The Uses of Debt and Equity

Debt is a way to make an investment that could not otherwise be made, to buy an asset (e.g., house, car, corporate stock) that you couldn’t buy without borrowing. If that asset is expected to provide enough benefit (e.g., increase value, create income, or reduce expense) to compensate for its additional costs, then the debt is worth it. However, if debt creates additional expense without enough additional benefit, then it is not worth it. The trouble is, while the costs are usually known up front, the benefits are not. That adds a dimension of risk to debt, which is another factor in assessing whether it’s desirable.

For example, after the housing boom in the United States began to go bust in 2008, homeowners began losing value in their homes as housing prices dropped. Some homeowners were in the unfortunate position of owing more on their mortgage than their house was worth. The costs of their debt were knowable up front, but the consequences—the house losing value and becoming worth less than the debt—were not.

Debt may also be used to cover a budget deficit, or the excess of expenses over income. As mentioned previously, however, in the long run the cost of the debt will increase expenses that are already too big, which is what created the deficit in the first place. Unless income can also be increased, debt can only aggravate a deficit.

The Value of Debt

The value of debt includes the benefits of having the asset sooner rather than later, something that debt financing enables. For example, many people want to buy a house when they have children, perhaps because they want bedrooms and bathrooms and maybe a yard for their children. Not far into adulthood, would-be homebuyers may not have had enough time to save enough to buy the house outright, so they borrow to make up the difference. Over the length of their mortgage (real estate loan), they pay the interest.

The alternative would be to rent a living space. If the rent on a comparable home were more than the mortgage interest (which it often is, because a landlord usually wants the rent to cover the mortgage and create a profit), it would make more sense, if possible, to borrow and buy a home and be able to live in it. And, extra bedrooms and bathrooms and a yard are valuable while children are young and live at home. If you wait until you have saved enough to buy a home, you may be much older, and your children may be off on their own.

Another example of the value of debt is using debt to finance an education. Education is valuable because it has many benefits that can be enjoyed over a lifetime. One benefit is an increase in potential earnings in wages and salaries. Demand for the educated or skilled employee is generally greater than for the uneducated or less-skilled employee. So, education creates a more valuable and thus higher-priced employee.

It makes sense to be able to maximize value by becoming educated as soon as possible so that you have as long as possible to benefit from increased income. It even makes sense to invest in an education before you sell your labour because your opportunity cost of going to school—in this case, the “lost” wages of not working—is lowest. Without income or savings (or very little) to finance your education, you typically borrow. Debt enables you to use the value of the education to enhance your income, out of which you can pay back the debt.

The alternative would be to work and save and then get an education, but you would be earning income less efficiently until you completed your education, and then you would have less time to earn your return. Waiting decreases the value of your education—that is, its usefulness—over your lifetime.

In the examples shown in Table 2.3.2, debt creates a cost, but it reduces expenses or increases income to offset that cost. Debt allows this to happen sooner than it otherwise could, which allows you to realize the maximum benefit for the investment. In such cases, debt is “worth” it.