Finance: Part 2 (Money, What Did You Expect?)

What’s the answer to 99 questions out of 100? Money. 

— Vanilla Sky (2001)

In Part 1, we used sushi to introduce the fundamentals of finance, namely the time value of money and the related concept of risk vs. reward. We talked about why we would discount expected cash flows from the future to figure out what they are worth to us today and the opposite process of projecting the value of money in the future (compounding).

We also said finance is related to everything, which is a bold claim, especially to those who, let’s just say, outsource their thinking on the subject and get along just fine. Therefore, from here we could go in an infinite number of directions (I will recommend some books and other resources below each post if you want to go down any of the many potential rabbit holes). We will try to build up from where we left off, (which ironically again means backing up), summarize topics that we can expand upon with dedicated posts or entire series later, and keep it easy to follow.

Coconut City 
Here is a grossly oversimplified explanation of what I mean when I say finance is related to everything: It starts with people (how quaint) and economics. For a long time now, people have been trading their goods (e.g. Prozac) and services (e.g. foot massages). People created money because at some point, the way I imagine it, in a place called Coconut City, one caveman wanted some comfortable moccasins and another wanted a cheeseburger (a week before the Original Paleo Diet caught on). The problem became quickly obvious: How many moccasins equal a cow? The cavemen both agreed that they needed an easier way of dividing things of value, because there was no way the bovine caveman was giving up an entire cow for a pair of shoes. We won’t even talk about how offended the cow would be if he was turned into a cheeseburger over one pair of moccasins.

So, the one with the shoes says, “Look, we have 100 coconuts laying around and we are 500 miles from an ocean (meaning I can’t make anymore coconuts). I will give you 100 coconuts for your cow and you give me 5 coconuts for the moccasins. You can use the remaining 95 to pay me to do your laundry, prepare your tax return, paint portraits of you, and so on.”

Discerning readers will want to unpack the above scenario (including the latent control and obligations represented in the coconut, the advantage of owning the cow, and what happens if the moccasin man decides he’s done folding clothes) which we will save for later. As the example hints, the reason you have heard of all sorts of things being used as money is because it is less important what it is and more important what it means (for our purposes here, let’s assume that money is roughly the same thing as currency).

Updating our scenario, the best modern explanation of a currency I have come across is something you would be okay getting paid your wages in and you would be comfortable paying your rent/mortgage/obligations in. The implication is that the people using it have to trust the value of it and the stability of that value. As long as we feel good about those, it doesn’t matter whether we use dollar bills, electronic dollar bills, or coconuts. Imagine if you did a month’s rent worth of work (say $1,500), then went to pay rent, and they said, “Oh sorry the value of the dollar dropped, so we are going to need $3,000.”

Connecting this to the example above, it would be like our caveman going to use his remaining coconuts and finding out someone snuck 100 new coconuts into their system. As everyone gradually figures this out, they now want 10 coconuts for moccasins and 200 for cows, and our original seller still only has his 95, which buys half as much as he was expecting when he made the trade. This is called inflation.

If you know any Venezuelans, this isn’t a hypothetical nightmare for them, this is happening. Here in the US, not immune to such possibilities and wishing to avoid similar inconveniences, we go to the trouble to make sure the word trust is on every coconut bill (economics meets psychology and sociology). This is not a coincidence. The implicit premise is: Trust us that we won’t “print” too much money and inflate its value away. (They have printed a couple trillion since 2008.)

Odds are, even before the butchered economics lesson above, you understood the theme: Money is important and we don’t want anyone messing with the value of it. The basic reason is because that we need things and it facilitates transactions of those things between people. Without it, we would get bogged down trying to compare values of unrelated things and it would take much longer to get anything done.

So, we have loosely defined money and we know from Part 1 that the recurring inflow of money is called cash flow. And if there is one thing I know, it’s that everyone likes the recurring inflow of money.

If everyone likes this stuff so much, why does it cause so much anxiety?

As it happened, the other people in our fictitious Coconut City liked the coconut-as-money concept¹, so once things were up and running, the cavemen started getting used to their cash flow. This brings us to another fundamental observation: people build their lives around assumptions and expectations. At the extreme, we assume the laws of physics remain the same from day to day — for instance, we take it for granted the sun will be up tomorrow. Although it sounds goofy to talk about it like that, you would not argue against the importance of the sun for very long. In fact, we could spend the rest of the day listing things that depend on the sun, but that’s not what we came here to do. So how does any of this relate to money and finance? All business, and thus finance, is based on expectations. We spend money on our debit or credit card based on expectations of how much money we have or will have. These expectations likely include Wells Fargo storing our electronic money safely and securely on its servers to relying on someone to give you the money they owe you. Businesses do the same thing.

Which leads us straight into one of the central insights of finance, neuroscience, and essentially anything human-related: When something you expect/depend on happening does not, it becomes the most important thing in the world. Have you ever walked into a public restroom expecting to take a normal breath of air when suddenly you were blindsided with a whiff of such a horrid combination of smells that your nose refused to inhale until the rest of your body escaped? That visceral disappointment is the same feeling an analyst somewhere gets when Apple sells 78 million iPhones instead of the 85 million he projected in his (financial) model. That is the same feeling a manager gets when his team fails to meet its sales goals. It is the feeling Elon Musk has right now with his Tesla Model 3 promises.

Effectively everyone has some form of cash flow that they are expecting and any time that number is less than what they have in mind, they feel like they have walked into that public restroom².

This intuition makes sense, but a surprising number of people do not think in these terms; therefore, if we do, we give ourselves an advantage in an important game.

We could keep going, but as they say, Rome wasn’t built in a two-part blog post. The Get-Rich-Quick type who might have found their way here based on the title might be disappointingly thinking, “WHERE’S THE MONEY LEBOWSKI!?”

We will get there eventually.


¹ You might think that taxing authorities are big fans of improvements in transparency and the ability to count things of value. They are.
² The author is designing his life to avoid both the metaphorical and literal interpretations of this scenario.

See also:
The Mysteries of Money (Venkatesh Rao’s cerebral series on money from his blog, ribbonfarm – the link is to the eBook)
US Debt Clock (interesting resource)

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