We all are aware of money. We interact with it everyday. In that everyday nature of our dealing with it, we tend to sometimes add and sometimes forget what it actually is. Here, I attempt to simplify the concept.
Money is the value within. Let’s understand this with an example. Picture a seed. A seed has the potential to create trees and trees create more seeds. In that potential for multiplication lies its value. So is the case with money. Money has potential – to create more money and to buy us things.
Everything has value. A shirt has value – monetary for the shopkeeper and functional or emotional for the buyer. Therefore, the action of buying and selling is merely exchanging of this perceived value between the parties.
To store the seeds, we’d then bundle them up together and store it in gunny bags. This is the same as what we do with money. We bundle it up and store it in currency. Just sitting in your storage, as time passes, some of the seeds go bad and lose their potential. So, now while the count of the seeds in the bag remains the same, the overall potential of the bag of seeds reduces. This is inflation.
Along comes another person and gives you an offer – hand over your bags of seeds to him to use, and in return he will return you the original number of bags and a little extra. We think, we are now able to reduce the destruction of value that is currently happening, and we agree to this arrangement. This is what bank accounts do to the value inside the count of our money.
Now, a farmer approaches you. He wants to deal with you directly rather than the banking person from above. He offers you the same deal as the bank, only the ‘little extra’ is more than what the bank is offering. He also adds a caveat – he will be able to return the promised value only if his crop succeeds. This is what companies do to raise capital via debt.
Before accepting this farmer’s offer, you analyze the farmer’s expertise in farming and the fertility of his land and other relevant factors, and then decide to take the deal. You do this as you believe, the chances of the farmer’s crop failing are very low. The chances of the farmer’s crop failing is risk and your analysis and assessment of these chances is the basis of risk management.
Another farmer also approach you. In your assessment of the chances of his crop failing, you find that the chances are comparatively higher than the first farmer, and are unwilling to deal this time. The farmer, in desperate need of seeds, offers to return even more seeds than the first farmer. In the desire for the potential of getting more seeds back, now you take the offer. This is the relationship between risk and reward. And, we also go through this process, for the additional risk an investment entails, we expect to be suitably compensated. However, it is clear here that just the act of taking additional risk does not ensure higher returns, it merely give you a chance that higher returns may come.
Now, farmer 3 approaches you. He does not want the burden of having to necessarily repay his debt (given that the crop does not fail). He makes an offer, wherein in return for the bags of seeds, he will share his crop (and thereby the seeds) with you. If the crop fails, you get back nothing. If the crop does less than average, you get less seeds back. If the crop does better than average you get more seeds back. Here, by the increase in the number of possible outcomes for you, your chances of getting back your seeds are lowered from the earlier construct. This essentially increases your risk. As established, you take the offer expecting a much higher return. Remember, this is just an expectation and not a guarantee of the return. This is what companies do to raise capital via sale of equity.
At this point, the options have become so many and so varied, that you now find it difficult to assess all the options. Here, an opportunist person, comes along. His offer is that he will do the assessment for you and deploy your bags of seeds in the various options, in accordance with a pre-defined purpose and philosophy. And, mutual funds come to be.
In this manner, from the simple understanding that money is the value held within, and that the count of money and the value of money are two separate entities, we can go on to understand the various facets of money and the markets. From risk planning to investment management, from micro finance to international economics can be built from here.