The Forces that Act on Your Money
A no-nonsense guide written by a layman, for laymen.
Thinking about money can feel exhausting and intimidating. Information about investing and money management tends to be complex or confusing. Finance is an area where misinformation is rife, emotions run high and it feels like everyone is trying to sell you something.
Many articles about money presume a lot of knowledge, leaving a novice like myself bewildered. Or they are written in the most overly-cautious manner like they are teaching a monkey to use a nail gun.
While I’m not a finance genius, I am a Tibetan monk at sifting through droves of information and cutting out the bullshit. So what I offer is a no-bullshit simple guide to the things that impact your money.
When there is a lot of noise and not much signal it is useful to start with core ideas. So let’s look at four main factors that impact the movements of your money:
- Inflation
- Federal Interest Rates
- Return on Investment
- Tax
These are like physical forces that pull and push on all money.
1. Inflation
Inflation is an invisible force that degrades cash’s value over time. You never actually see it change your money, instead, it makes everything else except for your money more valuable.
Your money isn’t being deflated, everything else is being inflated.
The ghostly nature of inflation means that most people never notice it, even if they feel its effects. It’s like a poltergeist moving objects in your house. With inflation, you will notice that shopping seems more expensive than it used to.
Your favourite restaurant has put its prices up, fuel seems to cost more, and your paycheck just doesn’t seem to stretch as far.
How much does this impact your money? In Australia, the rate of inflation has sat around 2.5% per anum over the last 10 years. So your $10,000 in the bank is worth 2.5% less each year. After three years it is worth around $9,300.
Price inflation does compound, which means that this puny percentage ramps up. And whilst it has averaged to 2.5% there have been inflation rate spikes up to 10% around five times since the 60s and up to 15% in the 70s.
It's hard to notice this impacting you because the actual bank balance remains the same — but inflation is directly impacting your finances right now.
An oversimplified metaphor: a bank account is a bathtub with a leak in it that drips out a small amount — this is inflation. Luckily you have ways to counter this, by having accounts that gain interest — like a tap adding a trickle of water.
Unfortunately, interest rates offered by the bank often aren’t strong enough to keep the tub level, let alone fill it higher. The leak is faster than the tap. At the time of writing getting 1% interest on a bank account is good, but if inflation remains at 2.5% then that account is shrinking 1.5% — not growing.
The leak is faster than the tap.
Almost all other classes of assets increase with inflation, like ships rising with the tide — but not cash. People with large amounts of cash will put it into another asset like stocks or property, or find higher interest rate accounts for their money.
Which brings us to our second vital area:
2. Federal Interest Rates
The federal interest rate is set by the Reserve Bank (Australia) or the Federal Reserve (USA). Each country has its own.
Technically it is the rate of interest that banks are allowed to trade money to one another. This is important because it trickles on to most other areas of the economy — including your bank account.
Why are banks loaning each other money you ask? Think of it like car wreckers or mechanics who trade parts with the other yards in town. Both sellers make money and the customer doesn’t have to shop around.
When interest rates are low, banks can easily transfer money with each other, so it is cheap for them to get money to lay out new loans. This means that they are happy to give out loans to businesses and citizens at a lower interest rate. They can afford to (and still make money).
The typical pattern is that lower federal interest rates reduce the loan, bond, and bank account interest rates. When rates are low you are unlikely to find bank accounts that will grant you much interest, but on the upside, mortgage rates will be lower.
The many different forms you can transmute your money into are impacted uniquely by changing interest rates. We won’t dive into that deep well just yet, so for now, just remember that federal interest rates are one of those forces to be aware of.
Inflation x Federal Interest
Federal interest rates and inflation are closely related. Part of the remit of the federal reserve bank is to counteract devastating runaway inflation.
This is done by increasing interest rates, thereby making money harder to come by and making it more valuable. It also reduces overall spending in the country, which further slows inflation because sellers keep their prices low to entice buyers.
So the government adjusts interest rates to control this inflation, while still keeping rates as low as possible to encourage normal economic activities.
The interaction between interest rates and inflation is worth knowing because it helps you understand how both these forces change. For instance, if you see risks for rising inflation you might also expect increases in interest rates as a second-order effect.
3.Return on Investment
Anything you put money into can earn or lose some amount called your return. Different investments have their own name for this return, but it is in essence the same.
Bank accounts or loans have interest, bonds have coupon payments or yield, stocks have dividends and growth, real estate has rent and value growth, and buying solar panels has electricity cost saved.
These can all be calculated into “what percentage does my money grow each year?”. Knowing this allows you to compare across all types of investments.
A side note: never forget to figure fees and costs into your calculations. A popular method in the finance world is to offer you some great returns, but not include all the fees.
There is a certain yin & yang with return on investment; things that have the highest return tend to have the highest risk or difficulty. A normal bank account will grant a lower interest rate than a term deposit where you have to lock it up for months. Bonds that have less insurance will often return more, and uncertain growth stocks have potential for huge profit.
Word of caution: Possibility of huge profit is not the same as huge possibility of profit. Just because something is risky doesn’t mean there is a chance for profit. Some investments are like skydiving without a parachute — risky and exciting, but destined to end in disaster.
Getting a high return is only one goal. People also want their money to be safe, and available enough for an emergency. This is a game of balance.
The message to remember is this: you can calculate your return on anything. Subtract your costs then determine how much profit returned to you per year — now you can compare anything you can do with your money.
4.Tax
It is fitting that we talk about tax last because it is the last thing anyone wants to think about. But like these other forces, it is vital because it impacts how much money is left for you.
Basically any income from an asset or interest is considered by the tax collector in a similar way as income from a job. A good rule of thumb is that if you are in a tax bracket of say, 30%, then the interest or dividends you earn will be taxed at that rate.
At its core earning $1000 from an asset will act similarly to earning an extra $1000 from an employer. The tax office doesn’t care whether you make your money selling homemade fudge, or from financial investments — so long as you let them tax it.
Importantly, just like any other side-hustle, you are only taxed on your profits. So if you incur costs to get your investments, these can often be subtracted from your taxable amount.
There are some useful tax exemptions in Australia to know about:
Capital Gains Tax Discount
When an asset is held, grows in value, then is sold, the profit is taxed at whatever rate your tax bracket places you in.
If this asset was held for over a year, then only half the profit is taxed — saving you money. This is known as the Capital Gains Tax Discount. This is mainly relevant to assets that grow in value, like stocks and housing.
Dividends, bond payments, and interest paid to you are not considered capital gains. These are a business paying you, not an asset growing in value. So these are generally not eligible for discount.
Offsetting is not taxed
If you have a mortgage offset account then this allows all money in it to be subtracted from your total mortgage — meaning you aren’t charged interest on it.
If your mortgage rate is 4% and you put $15,000 in your offset account then it blocks 4% of 15,000 being charged to you each year. This is basically the same as gaining 4% of profits. The main difference is it can’t be taxed — because you technically didn’t earn anything.
There are plenty of other tax tricks, but the main thing to be aware of is that tax isn’t something to ignore until the end of the year. Think about it when you are making any investment because it can be the difference between profit or not.
That’s it! (for now)
Interest, Inflation, Return on Interest, and Tax. Four key variables to know about with your money. I sincerely hope this essay helps you cut through the noise in the world of personal finance.
Another time I will write more about the main types of assets and the unintuitive nature of compound interest.
This stuff does not need to be complicated. These ideas are the trunk of the tree, they carry most of the weight. Onto this, you can add the more detailed aspects of managing your money, but you will never regret a strong trunk.
