Why Investing Works – Part 2: Understanding how Investments Create Wealth.

Having gone into how wealth was created in the previous post, we can now turn to a discussion of how investing creates wealth.  I’ve recently had a long discussion of this and how it relates to the current pay-as-you-go Social Security system with an individual on another blog.  It is clear that he will never understand the concept of the growth of wealth, but it is nice to have the discussion.

Let’s say that one puts a portion of one’s wealth into gold bars as one works.  As discussed previously, while the value of gold may ebb and wane due to bubbles and troughs in the interest in gold, the value of the metal stays fairly constant.  This is because the supply of gold has been fairly fixed, the metal is rarely consumed, and people’s level of interest in owning the metal is about fixed.   The value of the metal in dollar terms would therefore be expected to grow at the rate of inflation.  This means that just as when the coins were made of an equivalent amount of precious metals as the value of the thing for which they were being traded, one should expect to be able to trade one’s gold bars in the future for an equivalent amount of work and goods as one put into buying them.

If the gold bars were one’s retirement plan, if one worked extra to gain the income needed to buy the bars from the time one was twenty to forty, one could expect to trade that extra work for necessities, by selling the gold bars, when one was seventy and could no longer perform that work.  For example, if one worked as a carpenter and put aside some of the income gained from building houses, one could get the equivalent amount of work from someone who mowed one’s lawn or provided medical care by selling those gold bars.  This is a fairly good system since it allows one to work while young and strong to provide for one’s needs when older.

What is provided by a pay-as-you-go system, like Social Security, is a similar concept except some of the value of your work is used immediately by individuals before you.  It is then expected that others will provide some of the value of their work to you when you are old and unable to work.  This concept will work if the people after you are willing to give you enough of their work (in the form of money from their paychecks) to provide for your needs and there are enough of them to provide for all of the needs of those currently retired.  The issue comes when there are not enough people working to provide sufficient resources to those who are retired, as is currently the case in the US where the retiring population is large compared to previous generations.  The extra wealth that was set aside – that in excess of what was needed to provide for those before them – was spent on other things.  That wealth will therefore not be available to pay for their needs in retirement, forcing those who come after them (current 18-40 year-olds) to provide more of their income or for benefits to be cut.

Through investing, however, one can do even better than simply storing up work and getting it back.  The reason is that when one has an investment, the investment itself will produce things of value for which  others will trade, requiring little or no additional work on your part once the investment is established.  For example, one could start a business where one copies documents by hand for people in exchange for their goods or services.  The issue is that one would need to continue to spend time copying documents by hand to continue to receive things in return.

If one builds a copy machine, however, allowing one to create copies easily (although the amount of work and thought involved in creating the copy machine in the first place would be immense), one could trade things of value – copies – for other things of value with little additional work on one’s part.  In fact, if the copy machine is made easy enough to use, people can make their own copies, reducing your work load even more.

A corporation itself can be a thing that grows in value and has a worth, such that people will be willing to trade goods and services for its ownership.  Let’s say that you start a dog walking business.  Obviously at first you could simply walk the dogs yourself and collect money for your efforts.  If you were able to walk more than one dog at a time, you could multiply the amount you make for your efforts somewhat, but you would still be limited.

If you got enough business, you could hire an employee to help.  The employee would perform the work, but the amount that you would collect would be more than the employee was paid.  The employee would not be cheated in the arrangement – he or she would exchange some of the money collected for walking the dog for the ease at which he or she found jobs to do – because you made the arrangements.  The employee would be free to walk dogs on his or her own, but because you were able to provide them with more customers than they could find on their own, they would be willing to give up some of the income per dog walked in exchange for more work.

The business itself has value because customers come to you for your services – it has “goodwill.”  This means that someone might be willing to pay you simply for the name and the list of customers.   If the business grows large enough there is also value for the owner in that individuals would be more likely to work for you due to the perceived security that the larger business provides, so the business would have preference in hiring.

When investing, one is buying a part of a business.  Ideally this business will have the ability to create things that people are willing to trade some of their effort to get.  In addition, if the business is to be profitable and the investment is to generate a return, the amount of work customers are willing to exchange for the goods and services of the business will be greater than the amount of work the business must provide in exchange.  One could run a business where all of the money brought in is paid out in salaries and for expenses, but there would be no profit and little or no value to the business.

For the investor this means that if one puts money into an investment like a business, rather than a fixed-value asset like gold, one will end up with the ability to pay for more goods and services than one provided.  The profits generated by the business, and the value of the business itself, will grow over time .This means that one will have more resources available than one provided.  Note that this was not gained through cheating people or doing something unlawful (in most cases).  This was done by providing the goods and services that people wanted, thus making their lives a little better, in an efficient way such that the good or service provided required less labor than the value for which it was traded.

Your investing questions are wanted.  Please send to vtsioriginal@yahoo.comor leave in a comment.

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Disclaimer: This blog is not meant to give financial planning or tax advice.  It gives general information on investment strategy, picking stocks, and generally managing money to build wealth. It is not a solicitation to buy or sell stocks or any security. Financial planning advice should be sought from a certified financial planner, which the author is not. Tax advice should be sought from a CPA.  All investments involve risk and the reader as urged to consider risks carefully and seek the advice of experts if needed before investing.

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