The door to wealth


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The door to wealth

  1. 1. GSBS6150 Individual Financial Planning Trimester3 2011 Student number: 3136767 Student Name: Lei Zhao The door to wealth: From Babylon to the 21st CenturyIntroductionRegardless of what people do, their own habits will determine their success or failure.In financial planning, everyone has their own approaches to manage money,however an excellent financial plan can help people avoid investment errors andenhance the chances of success. Financial plans do not only manage money but canalso develop ways of making money, saving money and using money to make money.The finer concepts of financial management are developed in the classical financialbook, ‘The Richest Men in Babylon’. This book recognises basic financial principles toincrease wealth. Two of the seven principle known as ‘Cures’ will be discussed in thisessay, namely the second principle dealing with ‘Control the Expenditures’ and thethird principle ‘Make the Wealth Grow’. In addition, I will develop some specificstrategies to apply these two important principles.The second cure: ‘Control the Expenditures’Arkad warned not to confuse the necessary expenses with desires. Desires arealways in a person’s life and are never endless. Compared with increasing desires,the wealth that a person owns is never enough. When wants and desires rule aperson’s mind, then family values and reason are neglected. Perhaps, the onlyapproach is to use some effective tools, such as journal for records and a budget.The correct use of these can help people recall expenditures and avoid mistakes thatlead to the loss of wealth.I believe that controlling expenditure is more important than tightening the budgetbecause unexpected expenses can cause a deficiency in a strict budget. For example,to a salaried person with a certain monthly income, some unexpected expenses areimpossible to control. Moreover, people who have their own business cannot be sureof their monthly income and so find difficulty in controlling their budget. Therefore,recording and tracking their actual expenditure is more feasible. Through analysingand summarising those expenditures, how the money is spent can be recorded.Indiv idual income statements and balance sheets can be utilised to classify the 1
  2. 2. GSBS6150 Individual Financial Planning Trimester3 2011 Student number: 3136767 Student Name: Lei Zhaoexpenditures, and help people to control their expenses and cut unnecessaryspending.The preparation of indiv idual financial statements can help people grasp the extentof their expenses and cash flow situation. A large number of people record theirexpenses every day, but these records are only in the form of a cash journal. Thiscannot help people find out directly their problems regarding consumption. Theyneed a more advanced accounting method to determine these problems. Anindiv idual income statement and balance sheet is an excellent choice for this purpose.The individual income statement records the earnings and losses over a certainperiod, and incomes and expenditures could be recorded either monthly or annually.The balance sheet used to determine the assets and liabilities at a particular point intime. Using these financial statements, all expenses can be classified, and theproblems of consumption habits can be more easily identified.Generally, there are three types of household expenditure, fixed, variable andunnecessary expenses. For example, loan, insurance and property management feesare fixed expenditures and should be paid as a fixed amount at a regular period.There is no possibility for saving with these fixed expenses, and should be reservedat first. Normally the variable expenditures are daily household expenses, such asclothing, food and utility costs. These are essential household expenses and reflectthe family’s basic living standard, but the amount is adjustable. However this kind ofexpenditures should not be too frugal, and it should be reasonable to be effective.The last type of expenditure involves some unnecessary expenses and is always alarge sum of money; for example, travel, beauty treatment, entertainment or luxurygoods. To reduce household spending, the most important thing is to control theseexpenditures in conjunction with a reasonable target to suit the actual economicsituation.The third cure: ‘Make the wealth grow’After saving more than 10% of personal income and cutting unnecessaryexpenditures, part of the earnings is kept. Nevertheless, if the wealth growth ratedoes not exceed the inflation rate, a decrease in purchasing power will result in aloss of wealth. In addition, poor investments also reduce hard-won wealth. Soobtaining the steady growth of wealth is the problem that needs to be solved. In 2
  3. 3. GSBS6150 Individual Financial Planning Trimester3 2011 Student number: 3136767 Student Name: Lei ZhaoBabylon they recognized the extraordinary power of compounding income, to earninterest by lending money. Furthermore, those who could grasp fleeting investmentwere more successful because their wealth increased rapidly due to their excellentactions and wisdom.Compared with ancient Babylon, some modern investment theories and financialinstruments will now be explained; especially the High-Frequency trading strategy.6,000 years ago, there were only a few ways to make money with money. Thesewere by earning interest through lending money or by purchasing property to obtainrental income. However, in modern society, there is no doubt that there are moremethods available for profitable investment than 6,000 years ago. Modern financialsystems not only include private capital lending and borrowing, real estate sales andleasing, but also include a highly efficient banking system and various financialmarkets such as bonds, stocks, futures, foreign exchange and funds markets. Thesefinancial instruments are still in a continuous stage of innovation and development.However, along with the growing number of financial instruments, risks are alsoincreasing. How to avoid these risks is the crucial question that has to be solved.Moreover, as we know, the global population has reached 7 billion, a much greaterpopulation than in ancient Babylon. Adam Smith (1776) in ‘The Wealth of Nations’questioned which of the following was growing faster, available profit activities, toolsand opportunities or the population explosion. It is obvious that only the minority canutilize these profitable opportunities to achieve their rich dreams, although in theorythese opportunities belong to everyone. In the 21st century, investment opportunitiesare not obvious and are difficult to calculate with simple arithmetic.Therefore the ‘opportunity explorers’ have appeared in every market. They haveutilized their wisdom, complicated calculation methods and the most advancedcomputers to seek ‘the door of wealth’. They have created some trading models tolimit those risks that result from subjective and non-rational behav ior to achieve anappropriate risk-benefit ratio. These trading strategies have new names such asQuantitative Trading, Algorithmic Trading, Program Trading and High-Frequencytrading, which are much more analytical than the citizens of Babylon used.In High-Frequency trading field, James Simons is a legend. In his early career, heemphasized fundamental analysis. Afterwards, he set up a company, named 3
  4. 4. GSBS6150 Individual Financial Planning Trimester3 2011 Student number: 3136767 Student Name: Lei ZhaoRenaissance Technologies Corporation, that relied totally on computer models to doone hundred percent of the transactions. The business has developed to almost alltradable and high liquidity markets. The Medallion Fund of the company created in1988 uses models to predict future movements and capture those fleeting marketopportunities through thousands of daily quick trading, where trading volume couldaccount for even greater than 10% of NASDAQ total trading volume. In 1990, thenet return of the Medallion Fund was 55.9%, the following year was 39.4%; aftertwo years were 34% and 39.1% respectively. In 1990, the American Federal Reserveraised interest rates six times, but net profit of the Medallion Fund was 71%. In 2000,the stock market crashed due to the Tech bubble, the S&P index fell by 10%, but theMedallion Fund performed well with a net return of 98.5%. As a result, in 2005Simons became the worlds highest-paid hedge fund manager. From 1989 to 2006,the average annual rate of return was 38.5%, which exceeded Warren Buffett’sreturn rate. Even in the 2007 Subprime Crisis, the fund return was as high as 85%.The key to the success of High-Frequency is to maximize of the compounding powerand seize every fleeting investment opportunity, as this is consistent with Arkad’sthird principle of wealth. High-Frequency trading just utilizes more scientific andefficient investment tools and theories.ConclusionThe financial wisdom of ancient Babylon is still valid today, as the seven principles ofwealth are consistent with modern financial theories. Situations described in theprophetic stories of ancient Babylon’s financial principles are still valid today. Thereare many methods and strategies to achieve ‘Controlling Expenditures’ and ‘WealthGrowth’, but these methods and strategies need be learned and applied. Control ofexpenditures, even though indiv idual financial statements are completed, continuesto be useless if people cannot effectively cut unnecessary expenditures. For peopleseeking wealth, even the best investment approaches do not ensure steady andrapid growth of wealth because of too much greed and fear. For financialmanagement, the most essential thing is the use of wise financial habits. Whenpeople have sound financial habits, they can open ‘the door of wealth’ and maintainit. 4