How to Value Money?

I have been staggered by certain aspects of money. For a long time, I tried to figure out these puzzles. I am not entirely sure if I have cracked it completely but I can tell you I have understood something.

"Something is better than Nothing"

So, first let us understand Price and Value.

I remember the days around year 1995 when a kilo of Watermelon would cost Rs.5/Kg and there would be vendors under the trees selling a slice for Rs.2

Fast forward to 2020. A kilo of watermelon costs Rs.20/Kg and a slice is sold at Rs.10 by the same vendor.

What has changed?

Value or Price?

Take a couple of minutes to think before proceeding further

One thing that is certain is that the price has changed. But, what about the value?

Value of the Watermelon has not changed. Or has it?

It still tastes the same. It has the same health benefits. I am also sure that it does not cure Covid19. So I hope you would agree the value of the melon hasn't changed.

But what about the value of Money?

The value of Money has depreciated so much that 15 years later you pay 5 times more for the same piece of damn melon or 4 times more for a Kg of Melon.

This is the simplest means to understand inflation.

Now, let me give you a mental model to evaluate the depreciation (also works for appreciation).

Rule of 72

What Is the Rule of 72? The Rule of 72 is a simple way to determine how long an investment will take to double given a fixed annual rate of growth/depreciation. By dividing 72 by the annual rate of growth/depreciation, one can obtain a rough estimate of how many years it will take for the value to double itself.

Conversely, By dividing the number of years by 72, you can figure out the rate at which it has to grow/deprciate to double.

So take the case of watermelon.

It has doubled twice (4 times) in 15 years. Or, It doubles every 7.5 years.

So, the inflation = 72/7.5 = 9.6%.

Basically, one has to grow your money at 9.6% every year to retain the value of your money. In other words, to buy the same piece of watermelon after one year you need 9.6% more money.

Or

Practically, If your yearly increments of your salary is not 9.6%, you are becoming poorer & not richer.

Now, let's do a reality check to figure out if you have comprehended the idea of Value of Money.

Case Study - Island of Manhatten

Manhattan is easily the one of the top 10 costliest Real estates in the world. It covers roughly 60 sq. Km of land.

In 1626, Dutch West India Company purchased the Island of Manhattan for US$ 24 from the Native Americans. (The situation roughly translates to buying Chennai for Rs.1800 in year 1626.)

What is your opinion on this deal? Who is the real beneficiary of the deal?

Were the Dutch company clever to buy one of 20th century's most valuable real estate for USD24 in 1626?

OR

Were the Native Indians clever to sell the most valuable real estate of 20th century for an handsome US$ 24 in 1626?

What is your opinion?? Make your mind up.

So, lets try to evaluate the deal.

To make it easier, we have to value US$ in today's terms.

In order to do so, we have to understand the historic rate of inflation. We have had various trading systems thru this period inflation is estimated to be between 6-10%. A widely accepted value is 7.5-8%.

For the ease of calculation, let us consider 7.2%.

Let us use the mental model of 72.

Remember, Next time - I want you to train and do it in the mind.

So, according to Rule of 72,

No.of years to double = 72/7.2 = 10 years. (A slice of melon costing US$24 in 1626 will cost US$48 in 1636.)

If it takes 10 years to double, Between 1626 and 2026 (2026-1626 = 400 years),

Then,

400Yrs/10Yrs= 40 doubles.

So, after 400 years, US$ 24 would value,

US$ 24 x 2^40.

or

=24 x 2^10 x 2^10 x 2^10 x 2^10 ( 2^10 = 1024 ).

For simplicity, consider, 2^10 = 1000.

=24 x 1000 x 1000 x 1000 x 1000

= USD 24,000,000,000,000 or 24 Trillion.

Simply put, The Dutch company has purchased Manhattan Island for USD 24 Trillion in today's terms.

It might not seem significant to you because you do not know the value of US$ 24 trillion or what you could buy with that money.

If I have to draw parallel's, you go to Prestige builders who is building a nice cozy apartment in the middle of the city.

He says, an apartment in the top floor with the view of the whole city costs 2.5 Crores.

Whereas the builder right next to him in the same location offers at 2 Crores and no discount.

But, due to corona Prestige offers it for 1.5 Crores. A discount of 40%.

Your mind says, "Wow!! Just take the deal ".

Unfortunately, Human brain cannot value anything in absolute terms but only in relative terms.

Lets get to the final conclusion on the Manhattan deal.

Since we know human brain can only value things in relative terms, let me make a comparison.

If you want to own everything in this world, you would roughly have to pay US$360 Trillion in 2019 which is the total net worth of the world. (Try Google if you don't trust me)

Even if it costs US$ 400 trillion in 2020 to own everything in planet earth, Compare that to the US$ 24 trillion deal?

The Dutch have paid 16% of the cost of the whole world to own a paltry 60 sq.km real-estate in Manhattan.

How stupid?

So, think about the value of anything before buying!