Monday, June 23, 2014

Investment Choices: Part 1, Interest

I'll have you all know that this is one of the first posts that I set out to write.  It's been shelved time and time again, for the simple reason that I haven't been able to figure out how to introduce the topic.

There are two ways to get money: earn it by working for it; or earn it by using it to make more of it.  Investment is the second one.

A large rabbit, surrounded by zillions of smaller rabbits.
If money were rabbits, investment would be easy.

That's pretty broad statement, and basically means that everything could be an investment.

An infographic: "Locate fertile farmland" leads to "Buy farmland, equipment, seeds ($$$$$$)" leads to "Add time" leads to "add labour" leads to "harvest crops" leads to "sell crops, profit ($$)" which closes the loop.

An infographic: "Come up with business idea" leads to " Develop, test, evaluate, research, pitch, fund idea ($$$$)" leads to "PROFIT!!! (Hopefully) ($$$$$$$$$$$$...)"

An infographic: "Identify valuable thing(s)" leads to "buy thing for low price ($$$)" leads to "add time" leads to "add effort" leads to "sell thing for higher price ($$$$)"

My plan, the plan that I'd been working on for months, was to define and describe all of the different investment mechanisms that I could think of.  A quick search of the internet revealed that other people already wrote definitions of investment mechanisms.  You can find a few choice examples here, here and here.  

Giving financial definitions isn't really my specialty, anyways.  I'm better at stories.  Today I will tell you a story about interest.


My mom had a limited patience for picture books, particularly if she had to read them.  

me, my mom and my sister sitting together on a bed.  My mom is reading a story and looks annoyed.
"One fish, two fish, red fish, f*** this."

As a result, by the time I was 7 or so, bedtime stories for me and my older sister involved a wide selection of books that an adult could find interesting.  We read the entire collection of Calvin and Hobbes, we read Beverly Cleary, we read For Better or For Worse.  On one notable occasion, we read "A Wrinkle in Time" by Madeline L'Engle and I understood none of it.

Me, my mom and my sister sitting on a bed.  My mom now looks happy reading the story.  I look unconvinced.
“Qui plussait, plus se tait. French, you know. The more a man knows, the less he talks.” 

Me, my mom and my sister sitting on a bed.  My mom now looks happy reading the story.  I look bored.
“You mean you're comparing our lives to a sonnet? A strict form, but freedom within it? Yes. Mrs. Whatsit said. You're given the form, but you have to write the sonnet yourself. What you say is completely up to you.” 

My mom, my sister and I could all agree on the Little House Series, by Laura Ingalls Wilder.  It is a curious thing as a kid imagining that people older than you might have ever been kids themselves.

A picture of 70-year-old Laura Ingalls Wilder's head pasted on a cartoon body carrying a teddy bear.  The picture is in sepia tones.
Maybe.  But probably they only saw in black and white.

'Farmer Boy' is a book about Laura Ingalls-Wilder's husband's childhood.  Reading it, it's hard to miss that money is a theme.

Take for example this description of Almanzo's father:

"Almanzo's father was an important man.  He had a good farm.  He drove the best horses in that country.  His word was as good as his bond, and every year he put money in the bank."

Cartoon mimicking the "American Gothic" painting, only the farmers are wearing bling and the man is carrying a wad of money.
"He was a man of the soil, if by soil you mean money."

Later in the book, Almanzo receives a $200 reward for finding and returning some really rich guy's wallet.

A fragment of the picture from the book.  A scrooge-like man is cringing away from a burly man who is shaking his fist and holding the shoulder of  Almanzo.
Pictured: the rich guy (left) willingly giving a reward to kind young Almanzo.

Almanzo's father takes 9-year-old Almanzo to the bank to deposit the $200, whereupon he spends a few paragraphs rhapsodizing on the wonders of the interest that Almanzo will earn on this investment. 

Almanzo, holding his father's hand and a wad of money.  His father looks happy and is talking.
"Because you'll have $200 in the bank, they'll pay you interest each year.  At 5%, that's $10 in the first year."
Almanzo, holding his father's hand and a wad of money.  His father looks happy and is talking.
"In the second year, that's $10.50."
Almanzo, holding his father's hand and a wad of money.  His father looks happy and is talking.  Almanzo now looks bored.
"...and after 10 years, supposing the interest rate stays the same and that you don't deposit anything further, you'll have $325.77!"

The book is very specific; but alas, I don't own the book anymore and the internet isn't giving me the answers that I need.  Let's say he earned 5% (based on this source)

At 11, I wondered how much money Almanzo could have expected to earn on his investment in the long term.  I pulled out my calculator and started multiplying.  I wanted to know when his investment would double. 

Me looking intense, writing out each year's interest earnings on a sheet of paper.

There are two ways to calculate interest, depending on whether the interest is simple and compounding.

Simple interest uses simple math:

The formula for simple interest, with my calculation showing that it would take 20 years to double the money.

Compounding interest uses complicated math:

The formula for compound interest, with my calculation showing that it would take 14.2 years to double the money.
This isn't how I did my calculations when I was 9.  One physics degree later, I have a few more tools in the mathematical tool kit.
Using either calculation, young Almanzo would have needed to wait for decades to turn his money into anything approaching a retirement fund.  

After my analysis, I was left wondering if interest was a good way to earn money in the long term.  I decided then--and in this era of sub 1% interest rates am even more convinced--that leaving money in a bank account is not a good investment.

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