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Finance Myths and Fundamentals

September 26th, 2014 at 09:26 am

I was discussing this article with someone online the other day, and when I mentioned that the SO and I actually did reach millionaire status by age ~30 via saving rather than focusing on income, I received what I initially thought was an odd response.

"But you don't have a million dollars in liquid cash", he said. "Stocks can go down as well as up!"

At first, I was really confused, because that comment was clearly meant as a dig, as if holding investments worth a million dollars is somehow not as legitimate as having a million dollars in cash, simply because the market could go down, but who in their right minds would (unless one were running a corporation) hold that much in cash?

But then I started to unpack the implicit assumptions in his statement, and I came to a few realizations about his point-of-view.

His comment makes the assumption (like many other people, I'm sure), that being "rich" or "wealthy" is about having a lot of money. But that is not the right way to think about it. Conceptually, money is merely an abstract representation of value, and cash is just a single form of that value. The technical and more inclusive term for "stuff with value" is "assets", and that includes anything that has monetary worth, whether it's cold hard cash, a stock portfolio, physical property, or a business.

Most individuals who are wealthy hold their net worth primarily in assets, not in cash, and there's a reason for that -- cash is static in value. I have taken three finance classes, and every single one of them opened with TVM, or the time value of money, which is a fundamental concept in finance that the value of money does not stay constant; it changes over time according to an interest or a market rate. Thus, in order for money to hold its purchasing power, it needs to earn an interest rate that is at least equivalent to inflation. That usually means not holding assets as cash, which can only depreciate over time, but as investments, which can appreciate over time.

The second part of his comment, about market fluctuations, assumes that a down market means you've lost money. But those losses are purely on paper, and would not be realized until the assets were sold, which any prudent investor should refrain from doing (if they can help it). I didn't panic at all in 2008; that was actually the year I switched to a much higher-paying job, and started hitting the 401(k) as hard as I could. And I plan on calmly riding out any future market downturns, so I'm not too phased by unrealized short-term capital losses.

Furthermore, there is another fundamental theory in finance called the Capital Asset Pricing Model, or CAPM. The basic take-home message of CAPM, as I understand it, is that risk and reward go hand-in-hand. (I don't claim to have a sophisticated understanding of finance theory, but not only was CAPM taught in finance class, it also won the Nobel Prize in economics, so I assume it's not completely full of shit.) I am chasing returns at this time, so I'm fine with taking on some risk. I am not going to fall for the trap of loss aversion like he seems to be, especially when I don't invest anything that I'm going to need anyway.

It's fairly unfortunate when people hold onto these incorrect assumptions, and they don't have a more mature understanding of how finances work. I feel like I've barely scratched the surface of this vast and fascinating topic, but what little I do know already makes a huge difference in how I approach my finances.

And that knowledge is power.

4 Responses to “Finance Myths and Fundamentals”

  1. creditcardfree Says:

    Nice post!! I was a finance major in college...so I get it. And yes, it is hard to explain these concepts to people if they don't have that basic understanding of TVM. No reaction here to market downturn in 2008 either...investing and getting more shares for our money.

  2. snafu Says:

    I appreciate the article that lead the discussion. Thank you for the cogent explanation of fundamental money management. I've always been bewildered by folks who focus on waiting and worrying about the next storm and therefore miss out on the ongoing sunshine.

  3. Bob B. Says:

    Your perspective makes perfect sense to me.

  4. Looking Forward Says:

    Nice post - Thumbs Up! Smile

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