Landon's Money Musings Newsletter: April 2022
French Teen v. Big Sis: Who will pay me back?
One summer while I was visiting Paris with friends after my high school study-abroad program, I lent my friend €80 to buy a nice pair of heels. She said she would pay me back on September 1st. When that date rolled around, she never talked to me again! That was a big chunk of money for me as a 16-year-old, and it was a risk I took on solely for the purpose of helping my friend.
Now, commercial lenders do the same thing but instead of doing it out of a communal sense of care and generosity, they do it for interest. They understand the concept of risk better than I did back then. Someone who has no income, over whom you have no recourse if they disappear—that would correspond to a high interest rate.
If I had thought about it like a commercial lender, I might have assigned a 25% interest rate (compounded annually) to my friend’s 15-years delinquent loan. Emmeline, if you’re reading this—you now owe me €2,274*!
Let’s say I go out with my sister, Alicia, and she forgets her wallet. I would consider lending her €80 to be extremely low risk. Get those heels, sis! My sister is very responsible and has a good job, and she has never disappointed me. I’ve also known her a very long time and seen her track record of not running off with anyone’s money. According to the U.S. Treasury Department, you are supposed to charge a minimum interest rate to any loan, otherwise it falls under gift tax rules. So my sister can have that €80 for an interest rate of 2.25% compounded annually. If she takes 15 years to pay me back, she’ll owe me €112*. I’m sure my sensible sister has a good excuse for taking so long though.
I’d like to make some euros, you say? Well, you have a choice. Do you prefer the slight chance of having thousands of dollars or the very good chance of having a hundred or so dollars?
These are calculations that are made every day in lending and investing. Perhaps you’d rather diversify by lending €40 to Emmeline and €40 to Alicia. To diversify further, you could even lend €4 to 10 French teens and €4 to 10 of my family members. That way, even if Emmeline doesn’t pay, likely some of the other young fools will. If half of them pay me back, you'll make €528 in profit*. If 90% of my family members pay you back (including Alicia of course, but maybe not wild “Gary”), then you’ll have made $10 in profit*.
When investing seems very opaque, it can be hard to contextualize the difference between the risks inherent in investing and the risks of any particular investment. But there is a difference. Tell me, which is more likely to happen in the next 15 years?
a) Alicia runs out of money
b) all of my family members run out of money
c) everyone in the world runs out of money
Clearly an individual is more likely to fall into hard times; it happens every day. Systematic failure is possible, but much less likely. Because of that, we typically we spread out the investments over many holdings. This reduces the risk exposure dramatically. It also reduces the potential for big returns and the excitement that comes with them. Nowadays, I try not to lend anything I can’t stand to lose, but it took me a long time to internalize that lesson. I used to lend just because I trusted and I wanted to share; the currency was love. What is the “interest” that’s lost when I keep my fondue pots** in the basement until I need them next rather than loaning them out so they can be enjoyed now? Well, here’s something that is lost. One time I lent my copy of Mindfulness in Plain English by Henepola Gunaratana to my friend Andrew. He was the one who first brought me to Lady Krishna’s late-night meditation group at 8-Limbs. My books are well-loved and I like to write little notes in the margins. About a month later he showed up ashen-faced and said that he had gotten my book soaked in water and couldn’t return it to me. Then he reached into his bag and produced a brand-new copy of the book into which he had meticulously reproduced every highlighted underscore and cryptic note to self. In a world where people not showing up is so routine that we can literally bank on it, I was touched that he had gone to so much trouble. I have the book that was kissed by his handwriting on my shelf to this day, and I will not loan it to you.
*Follow along on your financial calculator: FV: 15 I/YR: 25 PV: 80 PMT: 0 FV: -2,273.7 FV: 15 I/YR: 2.25 PV: 80 PMT: 0 FV: -111.7 FV: 15 I/YR: 25 PV: 40 PMT: 0 FV: -1,136.9; 1,136.9 / 2 – 40 = 528.4 FV: 15 I/YR: 2.25 PV: 40 PMT: 0 FV: -55.8; 55.8*.9-40 = 10.3 We’re saying this compounds annually, in other words it adds the interest to the value of the loan for the purpose of calculating the interest once a year. We’re saying they pay all or nothing exclusively at the end of the 15 year period. **This is just an example. I could stand to lose my fondue pots, though my signature Presidential debate fondue parties—Fonduebate—would be sorely missed. But you can totally borrow them. Other things you should know: This article is intended as an educational allegory for investing risk, not specific advice about investing by literally making loans to groups of people. The level of default risk, interest rate, and “performance” is also purely hypothetical, and of course not guaranteed. There is no guarantee that a diversified portfolio will enhance overall returns or outperform a non-diversified portfolio. Diversification does not protect against market (systemic) risk. Investing involves the risk of losing the money you invested. No strategy assures success. These opinions are for general information only and are not intended to provide specific advice or recommendations for any individual. I would need to get to know you better to make recommendations that make sense for you.