Even if you have won the lottery or received a significant inheritance, it pays to understand the basics of creating, growing and managing your wealth. You must become financially literate.The reason is simple. If you are financially literate you will make informed judgments and effective decisions about managing your money. Knowledge is requisite for doing things like saving money for your kids to go to college, buying a home, or planning your retirement. To presume the salary you’re making today will prove sufficient in empowering you to do these things is shortsighted. First, you must acquire the knowledge; then you must use your knowledge proactively.
To do that, however––to understand how wealth management works––you have to understand how the economy works.
That’s where we’ll start.
The Economy and the Multiplier Effect
The economy is a machine, and its functioning comprises the foundation atop which individuals and businesses create, grow and manage wealth. It’s all about money being made and money being spent. Many different types of transactions make the economy. To illustrate, let’s use a company we all know – Apple. Apple is a public company which means their stock and bonds are freely tradeable in the public markets. Private companies are not freely tradeable in the public markets.
Apple is in many different businesses, one of which is creating, manufacturing and selling iPhones. To manufacture an iPhone, Apple must purchase the materials needed to build it. Apple makes the iPhone case with aluminium and sapphire glass. Apple makes the battery with cobalt, graphite, lithium and aluminium. The screen includes rare earth metals like indium and tin. You get the picture.
A variety of companies supply the component parts. All of these companies employ people to produce their products and get them to market. In this case, the market is Apple. Every one of those companies is generating revenue from sales to Apple and paying their employees for their hard work. Then Apple uses these component parts to manufacture the iPhone and deliver them to their customers. Apple generates revenue on the sale to their customers and incurs costs for components and labor to manufacture the iPhone.
All the employees of Apple and their suppliers then spend the money they made in their local communities. They buy groceries, hire accountants, do improvements on their home or have their house cleaned. All these transactions contribute to the economy as money is made and money is spent. Therefore, each additional iPhone manufactured and sold impacts the economy each time money is spent. This is called the multiplier effect. As all these companies grow sales and profitability, there is economic growth.
Economic Growth: Creating and Measuring
Economic growth is measured by the gross domestic product (GDP) of a country. GDP is the total value of goods and services produced within a country over a period of time. An increase in GDP is the increase in a country’s production. In 2018, the United States GDP approximated 20 trillion dollars.
There are many factors which contribute to creating economic growth in a country or region. They include: the availability of natural resources, increased investment in physical capital like factories, machinery and roads, an increasing population of workers and investing to improve the skills of the workforce, improvements to technology, and legislation which promotes economic activity.
For example, economic growth is a function of employees fueling the economy with productivity. Increased productivity of workers, either through technology or a lower unemployment rate results in economic growth. This is one reason why the U.S. economy is growing right now. We have more workers contributing more meaningfully in their respective fields.
Now, your question likely is: but what does economic growth have to do with creating, growing and managing wealth?
The Economy’s Impact on Creating, Growing and Managing Wealth
When the economy is doing well, more people have enough money to buy what they need, but also to purchase what they want, and save or invest the remainder. When the economy is growing, there is more money available for investment and your current investments are more likely to be increasing in value.
Individual investors, based upon a number of factors, decide what type of investments they should make. Investors might select stock or bond mutual funds, exchange-traded funds, commodity funds, individual stocks or bonds or any one of many alternative investment products available.
Let’s once again look at Apple. Apple has stockholders who provided the capital necessary to grow their business. Those stockholders expect a positive return on their investment.
Stockholders realize a positive return when the company’s stock is worth more today than the day it was purchased. However, Apple also has bondholders who lent the company money to help them grow the business. The purchaser of these bonds make money by receiving interest from Apple for the use of their funds.
As the economy grows it is more likely Apple will become more profitable and the value of their stock will increase in value. If this occurs, it becomes more difficult for Apple to sell their bonds rather than their stock. Therefore, they will need to increase the interest rate the bond investor will earn in order to attract money away from stocks into bonds.
Investors’ Goals and Objectives When Managing Your Wealth
An investor should prepare their own analysis or evaluate analysis prepared by analysts before investing in a company’s stocks and bonds. The analysis should include both company fundamentals and the fundamentals of the broader economy.
Company analysis will use revenue, earnings, return on equity, profit margins, estimated growth and other data. This data helps to determine the underlying value of the company and prospects for future growth.
The economic analysis should consider things at the macro level such: as the global and individual country growth rates, geopolitical tensions, trade wars and trends. In addition, such analysis should include a more in-depth view at an individual country level such as: interest rates, inflation and employment trends.
There is no right answer on how investors should do their analysis. Every approach has its pros and cons. The key to becoming a successful long term investor will be to find a system that fits your goals and objectives. That is the purpose of this and future articles – to help you become financially literate and find the right tools and techniques for creating, growing and managing your wealth.
Knowledge is Key to Managing Your Wealth
If you believe you need education to teach your children about money matters, consider using e-books, webinars or other tools to increase your knowledge base. For example, our e-book “How to Budget, Save, Spend and Invest”, Owning Your Financial Future provides the necessary information to prepare you to teach your children.