Manage your Capital

Investment management is a very important subject. It refers to the process by which you make your buy-and-sell decisions on financial securities over the years.

Important as it is, however, it is only part of the entire picture.

Your financial market investments are only part of your overall capital, and the financial markets are only one of the different places you can invest your capital in order to create greater wealth. Real estate is another form of capital investment. Investments in businesses that are not traded publicly on the exchanges are another. While not actual investments, insurance instruments that you choose to purchase are yet another place you may direct your capital.

Economists define capital as wealth used reduplicatively -- wealth that is employed in order to create more wealth. When you loan money to a bank and receive interest, you are using your wealth in a reduplicative manner.

When the bank gets your money, however, they are likely to be much more efficient in employing that capital to create more wealth. They may loan it out to someone who is buying a house, and receive 6% interest. The money doesn't stay in the house, however -- whoever sells the house puts that money back into the system somewhere, some or all of it may go right back into a bank. Whether it goes right back into the same bank or not is immaterial for this illustration -- if this home seller puts it into a different bank, then a different home seller may put the money he receives into this bank, but for the purposes of the illustration, imagine that the home seller puts all the money right back into the same bank that loaned it to the buyer at 6% interest.

Now the bank turns around and loans it out to someone who is buying a car, this time at 8% interest. Again, the car buyer gives the money to the car seller, and the car seller puts some or all of that money back into the bank. The bank will then lend that money out again, this time perhaps to a credit card user who makes a credit card purchase at an even higher rate of interest, perhaps 10% or 12% or even 18%. In other words, the bank has used the capital it received reduplicatively -- it has used it multiple times in order to make more capital. A corporation will do the same thing, always analyzing where it will get the best return on its capital when it decides where to direct the capital under its control.

Wealthy families and individuals should think this way also, although often they do not. Wealth is different than capital: wealth is defined by economists as goods with value, and it can take the form of money which is simply a place-holder for goods with value (when you produce goods of value in your business, for example, you can trade them for other goods with value but more often you trade them for money, which you can then exchange for other goods with value at a later date).

When wealth is used in order to create more wealth, then it is being used as capital and not simply as wealth. Like a corporation or a bank, a family or an individual should examine the entire balance sheet of all of their wealth.

In the late 1950s and throughout the 1960s, rock climbing techniques were developed in the Yosemite Valley of California for ascending the spectacular big walls and cliffs there. This "Yosemite System" later spread throughout the world and still forms the basis for the system of placing ropes and anchors to protect a climber against a fall (the ropes and anchors are not used
to help ascend the rock -- only to stop a falling climber).

At the basis of the entire system is the anchor -- the connection of the person to the rock (or to a tree), often using nuts wedged into cracks and occasionally using bolts drilled into the rock. The anchor is the foundation of safe climbing -- following the Yosemite System, the belayer at the bottom of the rope is usually held to the rock by a system of three anchors or more. Trusting to fewer than three anchors is risking death in the event of a fall by the lead climber.

Likewise, with your capital, it is important to build more than one anchor as you "climb." Capital directed to the capital markets, in the form of stocks and bonds, for instance, is a critical anchor. However, it is far better to have at least three anchors, for example in the form of real estate and in the form of insurance instruments in addition to financial market assets.

It is possible, with the proper capital management techniques, to use wealth in a reduplicative manner between and among these different anchors -- to use the rents thrown off by a piece of investment real estate in order to pay the premiums on an insurance policy, for example.

This process is properly called "capital management" and it is a larger category than investment management (it includes investment management inside it). Understanding the distinction is important.

For later posts dealing with this same subject, see also:
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