Tuesday, March 22, 2011

Understanding Money

Money seems like a simple concept, involving only addition and subtraction.  But actually, there is calculus involved.

In control theory, we learn about the mathematics behind simple control systems.  And as it turns out, very simple systems - mechanical or electrical - can become very mathematically complicated in short order. Our familiarity with such systems and their apparent simplicity deceives us into thinking they are not complicated.

It is like an article I once read in Contact! magazine by engine designer Alan Lockheed, explaining the the effects of rod length ratio (length of connecting rod to crank swing) on engine performance.  At first, this seemed like a "simple" mechanical system, with compression ratio being the only variable.  But as it turns out, it is more complicated than that, with not only stroke, but acceleration and deceleration of the pistons being involved, and it turns into a bit of Calculus pretty quickly.

Money is also a deceptively simple system, which many folks assume needs only basic mathematics to model and understand.  You make money (addition) and then spend it (subtraction).  Maybe you need multiplication and division to understand interest, but that's about it, right?  And they'd be wrong - dead wrong.

Money has some interesting aspects, particularly since the other variable in the equation is the variable t or time.  Money over time, it seems, has a whole different aspect, and the calculations get complicated, quickly.

Compound interest, for example, can be your friend, allowing money to expand in value exponentially over time.  But then again, most people don't understand what "exponentially" means, and these are the folks who get burned by money - a lot.

For example, since they don't understand how compound interest works, they fail to save, and thus fail to take advantage of this wealth-builder.  Worse yet, they borrow - and borrow - and borrow - often at staggeringly high interest rates, and thus fail to understand they are paying 2-3 times the value of an item by tacking on interest charges.

And when people do bandy about financial terminology, like "opportunity cost", "equity", "depreciation", "cash-flow" or the like, they fail to understand what the terms really mean, an often just use them to justify bad financial planning.

For example, as I noted in one leasing debate, a fellow defended leasing a brand new car every three years on the grounds that it "improved his cash-flow."  He clearly had no idea what the term meant, but somehow thought that spending money was a good thing, financially, as it "kept his cash flowing".  This is, of course, utter nonsense.  You cannot spend your way to wealth.

Or one of those seminar people - who want to sell you a "wealth system" by getting you to buy the "Cash Flow Notes!" system.  It sounds like something cool, because it has the words "cash flow" in it, and people have heard that before, and let's face it, they like cash, and they like it flowing.  So what's not to like?

Opportunity cost is another term, used by economists, and misused by consumers.  Consumers self-justify bad financial behavior by arguing that it is better to borrow money, as if they pay cash, there is an "opportunity cost" in the transaction, because that cash could be invested at some hypothetical rate of return.  But what they fail to realize (other than they never had the cash in the first place, and are just using a post hoc justification to go further into debt) is that not paying interest is a sure-thing, in terms of investments.  The "rate of return" is equal to the interest not paid.  And of course, if you pay cash, you are tempted to spend less anyway.

Other aspects of money get even more complicated, and quickly.  The Stock market is one example, where changes in stock prices are anything but mere simple addition and subtraction.  Small changes in demand and supply can  cause HUGE changes in prices, and nowhere is this more true than in stocks.  A finaancial commentator on the TeeVee mentions a stock, and idiots like you and me, go out and buy it, like Pavlovian Dogs.  The price spikes.  Does this mean the stock is suddenly "worth more"?  Heck no, but we put our hand on that hot stove, again and again.

And of course, things like futures and other derivative instruments are even more complicated - as the name implies, these are first, second, and even third order mathematical derivatives (a term from Calculus) of the underlying stock price.   If you don't understand Calculus, you have no business in the derivatives market - buying and selling futures or options.  And yet, many an amateur, who knows little about mathematics, jumps into these markets, often taking options that could  be staggeringly expensive, if they failed to pay off.

And as our housing bubble (and all the other bubbles) illustrated, it is very hard for the average consumer to properly price commodities, like houses or gold, as our pricing cues are skewed.  Housing prices skyrocketed as interest rates fell.  But like in any control theory equation, an under-damped system can easily "overshoot" a correction, and end up out of control - which is exactly what we saw happen.  When emotions enter the equation, economic control theories quickly become un-dampened, as we are seeing now with the price of Gold.

Money is anything but linear, transparent, simple, or understandable.  As I have noted before, it is probably one of the greatest inventions of mankind - an invention that made possible most other inventions of mankind, including our society, our freedom, and our technology.  But it is a staggeringly powerful invention and one than can seriously injure a person, if they are not careful.

And this is why I suggest to anyone at any level of sophistication, that they simplify their finances as much as possible - avoid debt, pay down debt, keep things simple.  For example, a basic credit card with a low interest rate (7.5%) and a small limit (\$10,000 or less) is far better than some kickback-gimmick airline miles or reward card at 22%.  If you chase after complicated dreams, it will go all horribly wrong when they blow up in your face.

Like the control systems we studied in control theory, it turns out that a system with only a few nodes or elements can be very, very complex, even though it looks so deceptively simple.  Keep your finances simple and easy to understand, and chances are, you will be able to keep them under control.

Making things complicated - spending more than you make, leveraging yourself with debt, chasing after discount plans or reward coupons - only serves to distract you from what is really going on.

The basic cash transaction is the best and most transparent and easiest to understand.  People get into trouble with money, the further they get away from that sort of basic deal.  Strive for the simple!