What does this mean?
What is the purpose of having money? Is it so that you can put it in a bathtub and roll around in dollar bills (or hundred dollar bills) a la Scrooge McDuck? Money is used to purchase the things and the services that you want. Just as Austrian economist Ludwig von Mises explained in The Theory of Money and Credit, money is a medium to serve instead of barter.
Let’s look at why money serves the purpose it does, and then we can move on in our discussion about how that affects your financial life cycle. Basic economic theory explains that money serves as an intermediary to prevent us from having to barter all the time. Imagine if you were a shoemaker in a world without money. You make shoes which people need to keep their feet from getting injured or to sprint like Hussein Bolt. However, people don’t need new shoes all the time. They only need them occasionally, probably about annually. So, you have to find different people who need new shoes all the time.
So, with much hustling and effort, you’re able to get a steady stream of customers. What do they give you in exchange for your shoes? You need food, someone to help you build your house, clothes, water, security, etc. Therefore, for a barter system to work, you either have to continually match your shoes with people who both need your shoes AND can offer you something you need in return, or you have to centralize demand and supply through an intermediary. In this scenario, an intermediary would get rich because she could demand a pair of shoes, a dozen eggs, wood, and many other things for her services to save you from having to find all of those suppliers who also happened to need shoes yourself.
Instead, we use money. It is, in effect, a delayed exchange of goods and services. You make shoes and when someone buys the shoes, you get money. This money is a promise that you can buy goods and services you need sometime later. Now, you no longer need to go find someone who can supply you with food who concurrently needs shoes. Money eliminates the need for direct trading and for an intermediary.
Back to the present and how the function of money affects your life cycle planning. As we covered before, the purpose of money is to enable you to buy goods and services. There are three main ways to get money (and, no, the lottery does not count as one of the ways to get money):
- Earn money through work. From the time you cut grass as a teenager until you walk out of the office for the last time to go to your retirement party, people pay you for the value you can create. For most people this period of earning capability lasts between 40 and 50 years, and is the time when your human capital provides you with the most economic firepower. The more you can earn, the higher your chances of having enough money to do what you want without running out are. For most people, this is the biggest driver of monetary accumulation. That’s why I encourage people to invest in themselves.
- Earn money through investing. This is what people are trying to achieve through investing in mutual funds, bonds, stocks, CDs, and money markets. It’s also where private equity and angel investing fit. In essence, you are becoming the intermediary for others’ human capital. You indirectly pay someone else to create value and you get a piece of the profits from that value creation. Sometimes it doesn’t work out, and people create less value than expected, and you lose some (or all of) your money. We encourage people to use this means of earning money to meet or beat inflation.
- Receive money through inheritance. Sometimes, you strike it lucky. Rich uncle Willie, who you met once when you were a precocious 2 year old, took a shine to you and left his entire gazillion dollar estate to you. Welcome to the yacht club. Most of the time, you will either not inherit any money, or the money you inherit will not be enough to meaningfully influence your life. Depending on inheritance to secure your financial future is foolhardy and depraved. If you do this, you’re hoping someone else dies so that you can prosper. Sick. Furthermore, all it takes is one stroke of the pen, and that inheritance will go to Fluffy the cat. We encourage people to use inheritance, if received at all, as a windfall to add to ensure progress towards their life’s priorities.
For a vast majority of people, the first category is where they’re going to get a significant portion of their money – from working. They can either work for a boss or for themselves, but they’re going to have to work to earn money.
What about the primary purpose we discussed earlier – spending money?
Let’s assume that you work for 40 years, lived with your parents for 20 years (and therefore, had no independent expenses), and live for 80 years. This means that you have 40 years’ worth of earning power to account for 60 years of spending.
If you plot spending over time, it looks like a big hill and then a small hill.