Money has been the single greatest source of stress in my life for just about as long as I can remember.

In particular, there’s two aspects of money which have caused me the most stress:

First, how to make money, and second, how to manage money.

Now, we all have to solve for the Making Money problem first, but I’ve already already written about the process I followed to go from $80k in debt to multiple million dollar net worth in only a few years…

(so I recommend starting there if that’s where you’re at on your financial journey)

However, once you’ve made your first bit of money and you have around 6 months of funds set aside in case of an emergency, it’s time to start making your money work harder for you than you worked for it.

Which we do by way of a little thing called Investing.

Now, investing is a really big topic that I think of in two distinct parts:

1. The Theory of Investing

Which are the unique ways wealthy people tend to think about investing (which you need to adopt if you want to win the money game)

2. The Practice of Investing

Which is getting into the weeds of the different investment vehicles like real estate, stocks, and bonds, and how to manage your portfolio.

Now, in this week’s newsletter we’re just going to focus on what I believe to be the most important part: The Theory of Investing.

The reason this is so important is because:

How you think about money dictates how you act towards money.

If you don’t know how to think about investing, then you’re inevitably going to make bad decisions which will negatively impact your results

But here’s the thing, the ways of thinking about money that’ll actually help you win the money game are counterintuitive and probably won’t come naturally at first, which is why most people struggle with money.

So with that said, here’s a framework for thinking about investing that’ll actually help you win the money game and achieve a life of financial security.

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The Theory of Investing For Beginners

Now, I’m gonna say something here that will, at first, sound incredibly wrong and your instinct will probably be to call me an idiot.

But bare with me and I will explain:

See, in the world of money, we tend to overcomplicate things but the truth is:

There’s only ONE thing you can do with money:

You can spend it.

And that’s it.

Now, I can already hear the angry click-click of keyboards typing angry comments like:

Nah uh, you can Save It and you can Invest It and you can Give it Away.

So here’s the thing, you’re right.

But here’s how wealthy people think about money:

The thing that dictates whether or not you’re Saving or Investing money, simply depends on what you’ve Spent it on.

If you Spend money acquiring something that you expect to make you more than what it cost you, then we call that an Investment in an Asset.

If you spend money acquiring something that simply takes money out of your pocket, such as buying a beer at the bar, then we call that an Expense or a Liability.

So let’s use an example: Imagine we buy an ice cream machine for $100.

Is this an Investment or an Expense?

Well, it depends on what we do with the machine.

If we just use that machine to make ourselves a tasty treat every week, well, ice cream is great and all, but it’s not money going back into our pocket, so this is just an Expense in a Liability.

We’ve spent money and all we got out of it was ice cream.

But here’s the thing, it doesn’t have to stay a Liability. There’s two things we could do to magically turn this ice cream machine into an Investment.

First, we could start a business and sell ice cream for $1 a cone.

Now, if we sell a hundred cones, we’ll have recovered our initial investment into the machine and have an asset that’s producing ongoing profit.

This is what we call a Cash Flowing Asset.

That is, it’s pumping out money to us on a regular basis.

The second thing we could do to turn that ice cream machine into an investment is to sell it for more than what we paid for it.

For example, if I can sell that machine in the future for $150, then ultimately that machine made me $50 more than what I paid for it.

This is called an Appreciating Asset, which just means the thing gets more valuable over time.

But here’s the problem with Appreciating Assets:

You never really know what you’re gonna be able to sell it for down the road. At best, you’re just making an educated guess.

Now, some guesses are better than others, right?

A duplex in a highly desirable market is probably going to be worth more in the future than it is today, whereas an ice cream machine you bought from WalMart for $100?

Sorry, but it’s probably never gonna be worth more than what you paid for it.

Now, this all leads us to one of the most important investing concepts that the vast majority of people don’t understand:

Whether or not something is a good investment simply depends on the timeframe in which you measure it.

So, if you buy a house tomorrow and it produces $10,000 of profit in Year One, you might say that’s a pretty good investment.

But what if in Year Two the roof caves in and now you have to spend $50,000 to fix it?

Well, now it’s cost you more than it’s made you… so does mean it’s a bad investment?

Maybe… maybe not..

Because what if a guy knocks on your door the day after you finish fixing the roof and offers to buy the house for $100,000 more than what you paid for it?

All told, after accounting for the $50,000 roof repair and $10k of profit from year one, you could stand to make a total of $60,000 on this house.

So here’s the question:

Was this house ultimately a good investment?

And the answer to that is, again: It Depends.

See, the formal definition of Investing is to spend money with the expectation of achieving a profit.

So whether or not something is a good investment depends on what we EXPECTED to happen when we bought the thing.

If you thought you were going to generate at least $15,000 of cashflow every year and sell your hypothetical house in year 3 for $300k more than what you paid for it, then no: this wasn’t a good investment.

Because a good investment is one that meets or exceeds your expectations.

Okay, now this is a pretty advanced concept, but it’s important to start thinking about investing in this way because unfortunately most people just throw money at the stock market or crypto without any reasonably informed expectation of return.

They’re just following the herd.

Which isn’t investing…. In fact, we actually have a different word for this:

It’s called Gambling.

Which is just about the most unreliable way of winning the money game I can think of.

Alright, now let’s circle back to what I said at the very beginning, which is that the only thing you can do with money is Spend It.

We just covered how we call it Investing when you Spend money with the expectation of acquiring profit generating assets.

But what about Saving money?

Can’t you just stick it in a savings account at the bank or stuff it under your mattress?

Well, sure, you can do that, but what most people don’t realize is that they’re actually losing money when they do this.

And the reason for this is because: Saving is an Illusion thanks to a concept called The Time Value of Money, which simply states that a dollar today is worth more than a dollar tomorrow.

Here’s a thought experiment to show how this works:

Imagine you bury $100 in your backyard. That seems pretty safe and secure, right?

Well no, because what you can’t see is that ever year an invisible burglar slips into your yard and steals ~$2.50.

This burglar’s name is Inflation.

And this is a fundamental concept to understand why we invest in the first place.

See, inflation occurs for a lot of reasons, but one of them is because the cost of goods and services tends to increase over time.

For instance, a gallon of milk in 1950 would’ve cost you $0.83 whereas today it’s more like $4.28.

This occurs because of an economic principle called Supply and Demand.

See, over time as an economy improves, people start to make more money. As they make more money, they have more disposable income which increases the total amount of Demand the marketplace can exert on products.

Now, if the Supply of those products doesn’t grow faster than the Demand, this means we have more people competing for the same amount of goods which leads to prices increasing.

We call this rate of increase, Inflation, and over the past 30 years in the US it’s hovered right around 2.5% (depending on how you measure it).

Here’s what this means for you and your attempt to save money in the backyard:

If you dig up your cash in ten years, you’re gonna be shocked to discover that what could originally buy you $100 worth of stuff, is now only worth $75.

And the way to think about this is that you effectively SPENT $25 and in exchange you got to keep easy access to your money.

And this easy access has a special name that we call Liquidity, which is a concept that makes up one side of what’s known as The Magic Triangle of Investing.

This triangle includes the 3 characteristics of every investment that you have to balance depending on your investment goals.

It includes Security, Profitability, and Liquidity. Or put another way, Risk, Returns, and Accessibility.

Now, the theory of the Magic Triangle of Investing says there’s no way to maximize for all three sides. You can’t have a high return investment that’s also low risk and easily accessible.

There is always a trade off.

So let’s break down this Magic Triangle to understand how we can push and pull these different levers, starting with Liquidity.

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 LIQUIDITY

The easier it is to get to your money, the more liquid it is… but that easy accessibility comes at a cost.

For example:

Inflation is the price you pay for keeping your money under your mattress or in a checking account where you can access it at a moment’s notice.

One step up from this would be a high yield savings account where it might take just a bit longer to get your money, but in exchange you get some interest (historically between 1-2%).

Now, the thing to notice here is that your return is still below the rate of inflation.

Which means even in a high yield savings account, you’re still losing money over time because you’re paying for low risk liquidity which comes at the expense of a higher return.

And this is the reason that saving money is an illusion, because the only way to truly save money is by spending it on an investment that matches or outpaces inflation, and to do that you’re either going to have to compromise on how much risk you take or how accessible you want your money to be.

For example, there are investment vehicles like Government Bonds and Treasuries where you can get a rate of return that’s slightly higher than inflation and has low overall risk…the compromise with these investments, though, is that you have to lock up your money for anywhere between a couple months and a couple years.

So here’s the question you have to answer for yourself: is the increased security and profitability worth the lower liquidity? Or would you rather keep your money in a savings account where it’s not earning as much, but you can get to it and use it more easily?

And the answer for all of us is simply: It depends.

It depends on your individual context and what you’re hoping to get out of your investments.

But here’s a structure that’s served me well:

I like to keep around 3 months of living expenses (that’s like groceries and rent payments) in a checking or savings account so that I can get to it at a moment’s notice to pay the everyday bills of life. I keep another 6-9 months of living expenses cycling through 3-6 months Treasuries which at the time of this recording yield somewhere around 5%. This works well for me psychologically knowing I always around 12 months of savings just put away that I can get to relatively easily.

For the rest of my investments I focus on opportunities that range along the spectrum of risk and reward, which comprise the other two sides of the Magic Investing Triangle, so let’s break those down next starting with Returns.

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 RETURNS

When I first started learning about investing I read a book that had a profound effect on how I thought about money.

It’s a classic within the personal finance space called, The Richest Man in Babylon.

This is a fantastic book that I think everybody should read, and I think what I love most about it (besides the timeless lessons) is just how short it is. Shouldn’t take you very long to get through.

But within that book there was one concept in particular that reframed the way I thought about investing.

It’s this:

Think about your money as though they were workers whose primary job is to get you more workers.

This is called Investing, and the speed at which your workers bring you back more workers is your rate of return.

Now, this is great, but where things get really bonkers is when these new workers also start bringing you back more workers.

This has a special name that we call Compounding Interest and this might just be one of the most powerful concepts in the world of investing.

At least, that’s what Einstein believed.

Now, let me tell ya a story to show how this works:

Once upon a time there was a wealthy guy on his death bed who turned to his son and his daughter and gave them a choice.

If they chose Option A they could take their full $5M of inheritance in cash right there at that moment.

But if they chose Option B they would only get one single dollar in that moment… but the catch is that tomorrow that dollar would double and continue doubling for the next 31 days.

But not only that, the dollars that that dollar produced would also double.

So, on day one you’d get $1. On day two, you’d get $2. On day three, you’d get $4. And then $8 and then $16 and so on for the 31 days.

Now, the wealthy man’s son was impetuous and took the $5M now.

But the daughter was patient and more importantly she understood the power of compounding interest, so she took Option B.

The brother thought her a fool because by Day 20, with only 11 days left, she had only made $5,242.

But the daughter knew that time is an investor’s best friend and that the most important thing as the legendary investor Charlie Munger once said, “Never interrupt compounding unnecessarily.”

So she kept the faith… and by day 25 her inheritance had grown to $167,772…

Then on the next day, it was $335,544…and then $671,088…

And this continued until remarkably, on day 30, her inheritance finally surpassed her brothers at $5,368,709…

But there was still one day left…

And on that day, her total inheritance hit $10,737,418…

Over $5M than her brother who simply couldn’t be bothered to do the math and wait another month.

Here’s the thing:

This might seem like an extreme example (and it is), but this is how compounding works. You’ll spend years with barely any progress because it takes a long time to get the flywheel going, but once it does, your growth will take off like a rocket ship.

To see a real life example of this look no further than Warren Buffett who is widely considered to be the greatest living investor.

If you were to plot out Warren’s net worth over time, you would see this incredible exponential curve that starts around the time he turns 50 years old.

Now, at this point, he’s been investing since he was 14 years old, so that’s 36 years worth of compounding and his net worth is right around $250M.

Which is nothing to sneeze at, but it’s peanuts compared to what that number grew to.

See, 40 years later, when Warren turned 90, that $250M had transformed into $100B.

And that is just such a big number that it’s really hard to even comprehend.

Now, you might be tempted to think it only grew to such a massive number because of the insane returns Buffett was able to generate, but the truth is he only average a 22% return over the course of his life… which is great, don’t get me wrong…

But what this really demonstrates is that massive wealth can be created by generating moderate returns that are compounded over long periods of time.

And this is why you’ve probably heard that you should start investing as early in life as possible, because again if there’s once concept you take away from this video, let it be this:

Time is an investor’s best friend.

So start investing as soon as possible and then whatever you do, follow Warren Buffett’s two golden rules of investing which is:

“Rule number one: don’t lose money. Rule number two: never forget rule number one.”

Now, to avoid losing money, we need to understand the third side of the Magic Triangle of Investing:

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 RISK

Let’s start by defining our terms: Risk is the likelihood of losses compared to the expected return on an investment.

Now, this is easy to say… but the reality is this Risk is incredibly difficult to measure because in the world of investing we’re never dealing with perfect information.

Which means we often have to make our own best educated guess as to what will or will not happen in the future…

And as is always the case whenever humans start guessing, it’s a good bet that we’ll all guess a bit differently depending on a whole slew of variables unique to our personalities, education, and world-view.

This means that perception of risk in an investment is often subjective.

However, one of the really interesting things about humans is that while we will all probably guess a little differently, if you were to aggregate and average all the individual guesses, you would end up with a collective guess that is remarkably accurate.

We call this the Wisdom of the Crowds and to show how it works, let me tell you a story.

A couple hundred years ago this fella named Francis Galton asked 800 attendees at a livestock fair to guess the weight of an ox on display.

He got numbers ranging all over the place. Some were way too high whereas others were way too low, but when he calculated the median of all estimates, the Wisdom of the Crowd was only off by 9 pounds. That’s less than 0.01% off, which is incredible.

Okay, so here’s what this means when it comes to investment risk:

The investment wisdom of the MARKET as a whole, is generally pretty damn accurate.

Now when I say the market I’m really talking about the big three, which is the stock market, the bond market, and the real estate market. Now, I’m not gonna go into detail here on the technical side, but each of these markets typically prices assets along a spectrum of risk and reward.

As an asset gets riskier your desired return also increases so as to justify the additional risk you’re taking.

I mean, you wouldn’t play Russian Roulette for $5, right? No, you would only take on that level of risk for a life changing sum of money.

And for most sane people, there is actually no dollar amount that would make that game worth playing. The risk is just too high.

Now, here’s the unsexy truth:

Unless you are an extreme outlier with some unique skills and resources, you’re not going to consistently outperform the market…

So I recommend you don’t even waste the mental bandwidth trying.

The vast majority of investors would be best served by simply trusting in the Wisdom of the Crowd and pursuing stable investment opportunities that historically have moderate risk paired with moderate returns (between 5-15% annually).

So this means you probably don’t need to waste your time learning about exotic or esoteric investment opportunities that are going to generate a 10x return on your money. Sure, investing n crypto and luxury watches sounds fun on paper, but honestly, instead of trying to eke out a few more percentage points of return, what most wealthy people do is they put their money into something safe and boring and then they focus all their time and energy on increasing their earning potential so they have more money to invest in the first place.

And this leads us to the last thing you really need to understand about investing. It’s this:

Investing is inherently risky.

There’s no such thing as a guaranteed return. None.

So the most important thing is that you don’t invest money you can’t stand to lose. If it’s your last $100, don’t put it in the stock market. Hang onto you so you can pay your bills.

In fact, I mentioned this at the beginning of the video, but it’s so important that it’s worth revisiting:

You’re not ready to start investing until you have at least 6-9 months of emergency funds set aside to cover your living expenses.

Now, the best way to get to that first hurdle is by increasing your income and decreasing your expenses, which I talk about on a lot of the other videos on this channel, so go check them out next.

But remember, this is just Part One… We’ve now covered the Theory of Investing, but what comes next is the Practice of Investing.

Where and how do you actually invest your money?

If there’s enough interest, I will host a free live training breaking this down.

So if that’s something you’d like to see, shoot me an email with the words “Practice of Investing”.

And we’ll see you in the next video.