Chapter 4: Understanding Money
Understand money, wealth creation, saving, investing, inflation, and financial habits to build long-term financial freedom and stability.
I (Abhinav Mishra) published my book, ABC of Investing, in 2023, and it’s been 3 years now. To ensure the learning I have shared in the book reaches a wider audience, I am sharing all the content via this new newsletter. Every week, on Thursday, a new chapter will be released.
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A simple question for you: What is needed to invest? Money. So before we start investing, we need to understand money. You may be wondering, what is there to understand concerning money. We have a long-lasting relationship with money.
Those who have been married or are in relationships for years know that if you have been with someone for years, you cannot conclude you understand everything about the person. Just like humans, money has different layers. You may not understand it all after being in touch with them for years. Unlike humans, money is like an open book. The problem is that we don’t read the chapters. In this chapter, I will talk about all the crucial chapters every investor must know from the Book of Money.
Chapter 1: Money can lose value
The first thing you need to understand about money is that it can lose value. The culprit is inflation. Inflation refers to the increase in the prices of goods and services over time, resulting in a decrease in the purchasing power of your money. When inflation occurs, the same amount of money buys fewer goods compared to what it could previously. Let me explain this phenomenon to you through a simple example:
Assume you have Rs 10,000 in a savings account earning no interest. At the beginning of the year, the average price of a basket of goods—let us call it your dream shopping basket—was Rs 1000. With your Rs 10,000, you can purchase ten shopping baskets.
However, during the year, inflation kicks in, and the average price of the shopping basket increases to Rs 110. Now, with the same 10,000 rupees, you can only buy nine shopping baskets (with some cash remaining). It means that your purchasing power has decreased due to inflation.
In this scenario, inflation has effectively “eaten up” Rs 1000 of your money. Even though you still have Rs 10,000, the value of that money has diminished because it can buy fewer goods and services.
As time goes on and inflation continues, the erosion of purchasing power becomes more significant.
For this reason, I often say that investing in high-return assets is a necessity, not an option, especially in a developing country like India, where inflation is high. If you aim to generate 6 to 7% returns, you will never create wealth.
Chapter 2: The Time Value of Money
You can better understand money when you understand one of the most interesting concepts related to it - the Time Value of Money (TVM).
Assume a scenario, you were expecting some money from your uncle today, but he calls you and informs you that he will give you the money next year. How do you feel? You don’t feel good because you know you could have done a good deal with the money today than you could after one year.
It advocates that you are better off having cash now than later. Why? The answer to this question is explained by the Time Value of Money.
It is a fundamental principle that recognizes the idea that money received or paid at different points in time has different values. In essence, it acknowledges that a rupee received today is worth more than a rupee received in the future due to its potential to earn returns or interest over time.
The Time Value of Money is based on two key principles: the opportunity cost of money and the concept of compounding. The opportunity cost of money refers to the fact that if you have a sum of money today, you can invest it and earn a return or use it for consumption purposes. On the other hand, if you receive the same amount of money in the future, you miss out on the opportunity to invest or use it until that future date.
Compounding is the process by which an investment grows over time, as the returns generated by the initial amount of money are reinvested and generate additional returns. By investing early, you allow your money to compound and grow exponentially, thereby increasing its future value.
Let’s consider an example to illustrate the concept of the Time Value of Money. Suppose you have the option to receive Rs 10000 either today or one year from now. Assuming an annual interest rate of 5%, you need to evaluate the value of each option.
If you choose to receive Rs 10,000 today, you can immediately invest it or use it for consumption. However, if you decide to receive Rs 10,000 in one year, you miss out on the opportunity to earn a return during that year.
To calculate the future value of the Rs 10000 received today, we apply the compounding formula:
Future Value = Present Value * (1 + Interest Rate)^Time
Future Value = $1,000 * (1 + 0.05)^1 = Rs 10500
Therefore, the future value of receiving Rs 10000 today at a 5% interest rate after one year is Rs 10500.
Conversely, we can calculate the present value of Rs 10,000 to be received in one year using the same interest rate. The formula for calculating the present value is:
Present Value = Future Value / (1 + Interest Rate)^Time
Present Value = Rs 10000 / (1 + 0.05)^1 = Rs 9523
Hence, the present value of Rs 10000 to be received in one year with a 5% interest rate is approximately Rs 9523.
The example demonstrates how the Time Value of Money affects the valuation of cash flows at different points in time. Please understand that receiving money earlier is generally more beneficial because it allows for investment or consumption, which can lead to increased future value. Conversely, receiving money in the future is less valuable due to the opportunity cost of waiting and missing out on potential returns.
Understanding the Time Value of Money is crucial for various financial decisions, including investment analysis, loan amortization, retirement planning, and evaluating the profitability of projects or business ventures.
Chapter 3: Understanding Your Relationship with Money
You need to understand your relationship with money, and then only you will be able to become a good investor. So let me help you explore your relationship with money. You can put your thoughts in one or two words against each point:
Beliefs and attitudes
Each person has their own set of beliefs and attitudes towards money, which are influenced by upbringing, culture, and personal experiences. Some common beliefs include viewing money as a source of security, power, freedom, or even as a symbol of self-worth. These beliefs shape your thoughts and behaviors related to money.
Emotional attachments
Money can evoke powerful emotions such as happiness, anxiety, fear, envy, or guilt. Financial successes or setbacks can greatly impact one’s emotional well-being. People may experience joy when receiving a raise or a windfall, stress when facing financial difficulties, or envy when comparing their financial situation to others.
(Money invokes emotions Y/N - )
Money scripts
Money scripts are the unconscious beliefs and assumptions you hold about money that guide your financial behaviors. These scripts are often developed in childhood and can be influenced by the behavior and attitudes of parents or other significant figures. Money scripts can be either helpful or detrimental, shaping your financial decisions and behaviors ( ).
Money personalities
People have different money personalities that reflect their approach to managing money. For example, some individuals may be savers, focusing on long-term security and cautious spending, while others may be more impulsive spenders, seeking immediate gratification. Understanding one’s money personality can help in developing healthy financial habits.
(Your money personality is - )
Money and happiness
The relationship between money and happiness is complex. While money can contribute to basic needs, security, and comfort, research suggests that beyond a certain point, increased wealth does not necessarily lead to greater happiness. Factors such as personal relationships, sense of purpose, and overall life satisfaction have a significant impact on well-being.
Once you have understood your relationship with money, let me end the chapter by answering a question most investors have - how much percent of your salary should you save?
It depends on many factors: whether you are the only breadwinner, or you have a working partner, etc. While there is no one-size-fits-all answer, experts generally recommend saving at least 20% of your income. However, I push people to save at least 40% of their salary, especially if they don’t have debt like home loans and completed two years working (all desires fulfilled by then).
How much of your monthly salary are you saving?
“Money is only a tool. It will take you wherever you wish, but it will not replace you as the driver.” - Tony Robbins
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About me: In the last few years, I have noticed that many investors struggle with basic investment concepts. To address this, I have started a personalized newsletter offering easy-to-understand, actionable insights to help investors make better decisions. I have written over 5000+ financial blogs and want to share my knowledge and investing journey with you so you can become a confident investor. Join my journey.