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How Money makes Money

HomeHow Money makes Money

There are only two ways in which money making is done:

Money Makes Money

       I.         Hard work makes money

       II.        Money makes money

Investing is the art of employing money to multiply it.

Those in need of money for setting up or expanding a business are always willing to pay some premium for money. This is premised on their hope of making a higher return on this money compared to the premium that they pay for it (i.e. profit). When you buy shares in a company, this premium is nothing but the return generated on the invested money itself. This return comes to you, the investor in proportion to your investment in the company.

How does money reach those in need of it?

There are many ways in which money can be channelled to those in need. Banks move money between businesses and investors for a commission. Stock Exchanges are a great platform for channelizing money from investors to businesses. In either case, the underlying objective is to invest and make sure that your money makes money for you.

Besides the fact that money multiplies itself, another reason as to why you should invest, which people often overlook, is the effect of ‘inflation’. The rate at which the prices of goods and services rise (i.e. Inflation) causes money to lose its value over time. So your money will not buy the same amount of goods or services in future as it does now or as it did in the past. For example, if prices rise at a rate of 6% for the next 20 years, a Rs. 100 purchase today would cost Rs. 321 in 20 years. So remember, if your money doesn’t grow at a rate higher than the inflation rate, its value decreases over time.

Money makes money

Where all can you invest?

     ♦  Bank deposits or FDs, government bonds, shares, property, gold etc.

Which one is the best for you?

That would depend on how much return you expect to make and the risk you are willing to assume for such return.  This ‘SHOULD’ further be based on other factors such as the age of the investor, the horizon over which the investment is to be made and the portion of income or savings available for investment.

It is generally believed, that fixed income investments like bank deposits are safer in comparison to equity or share market investments. This may be true only if you invest in highly risky equities or complex derivative products. Let’s understand how you earn money on fixed income investments and equities. 

investing in equitiesTake the example of a simple fixed deposit (“FD”) with a bank. Banks accept deposits and extend loans to their customers charging a difference in the rate at which this is done, i.e. commission. “Many fail to realise that banks don’t create money, they just move it around, and every time they move it, they charge a commission”. The primary function of banks is to put their depositor’s money to use by loaning it out to others. In the process, the bank keeps the difference in the interest rate it charges on loans and the interest rate it pays on deposits. So the fixed interest income which you earn on your FD, is a little below what the bank earns by extending your money further. 

When you invest in stocks, you become part owner in the company and are entitled to the profits generated by its business. Companies can either return the profit to the shareholders as dividends or accumulate the profits in reserves if the management feels that it may be able to utilise the money better and earn an even higher rate of profit in future by capacity expansion, making an acquisition or by new product launches. Of course, the management could also do a bit of both (i.e. pay part dividend and transfer the rest to reserves).

When you compare fixed income investments with equity investments, keep in mind that the return from FDs is taxable as per the income tax bracket of the investor and the effective post tax return rarely matches the inflation rate of about 7 %. For example, for someone who is in the 30 % tax bracket, a fixed deposit with a 9.5 % interest rate is effectively only about 6.5 %. This is why it is absolutely imperative that you invest right by putting a portion of your savings in equities as equities not only provide a hedge against inflation but also a tax advantage, in that you pay no tax either on dividends or on your long term investment (i.e. on the appreciation in the value of your shares held over one 1 year). 

stock market vs gold returnIn addition to fixed income and equity investments, there is a lot of buzz about investing in property and gold. The first has some merit but the latter, in my view is unlikely to sustain its rising price in the long run. In any event, when you compare gold vs. other productive categories of investments such as equities, you will realise that equities have consistently outperformed.

What then is the reason for all this hype with the yellow metal? Was it just that people wondered where to put their savings with the equity markets (and mutual funds) performing so poorly over the recent years? Or is it something else? Will gold also see an equity market like crash? May be not but as I said, we can discuss the reasons at length in another discussion. 

For now, let’s just focus on how money makes moneywith ‘safe equity investments’. I would not like to talk about large caps, mid caps or small caps in an effort to describe what may be ‘safe’ but if you can understand the correct way of defining an investment, you are unlikely to go wrong with it.

“An investment operation is one which, upon thorough analysis, promises safety of principal and a satisfactory return. Operations not meeting these requirements are speculative”.

                                                                                                                                                –        Graham & Dodd (Security Analysis 1st Edition 1934)

Investment is a full time operation performed after thorough analysis to determine safety of principal, in order to earn a satisfactory return. It is not that speculation does not earn you money; it just lacks the element of safety and certainty. 

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About the Author

Rajat Sharma pictureRajat Sharma is a well known stock market analyst and commentator. He has covered Indian markets for over a decade and is regarded for consistently identifying early stage investment opportunities. Attorney by qualification, Rajat has done extensive work for improving corporate governance and disclosure standards.