1. GSBS6150 Individual Financial Planning Trimester3 2011 Student number: 3136767
Student Name: Lei Zhao
The door to wealth:
From Babylon to the 21st Century
Introduction
Regardless 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 and
enhance the chances of success. Financial plans do not only manage money but can
also develop ways of making money, saving money and using money to make money.
The finer concepts of financial management are developed in the classical financial
book, ‘The Richest Men in Babylon’. This book recognises basic financial principles to
increase wealth. Two of the seven principle known as ‘Cures’ will be discussed in this
essay, namely the second principle dealing with ‘Control the Expenditures’ and the
third principle ‘Make the Wealth Grow’. In addition, I will develop some specific
strategies to apply these two important principles.
The second cure: ‘Control the Expenditures’
Arkad warned not to confuse the necessary expenses with desires. Desires are
always 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 a
person’s mind, then family values and reason are neglected. Perhaps, the only
approach 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 that
lead to the loss of wealth.
I believe that controlling expenditure is more important than tightening the budget
because unexpected expenses can cause a deficiency in a strict budget. For example,
to a salaried person with a certain monthly income, some unexpected expenses are
impossible to control. Moreover, people who have their own business cannot be sure
of their monthly income and so find difficulty in controlling their budget. Therefore,
recording and tracking their actual expenditure is more feasible. Through analysing
and summarising those expenditures, how the money is spent can be recorded.
Indiv idual income statements and balance sheets can be utilised to classify the
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2. GSBS6150 Individual Financial Planning Trimester3 2011 Student number: 3136767
Student Name: Lei Zhao
expenditures, and help people to control their expenses and cut unnecessary
spending.
The preparation of indiv idual financial statements can help people grasp the extent
of their expenses and cash flow situation. A large number of people record their
expenses every day, but these records are only in the form of a cash journal. This
cannot help people find out directly their problems regarding consumption. They
need a more advanced accounting method to determine these problems. An
indiv idual income statement and balance sheet is an excellent choice for this purpose.
The individual income statement records the earnings and losses over a certain
period, 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 in
time. Using these financial statements, all expenses can be classified, and the
problems of consumption habits can be more easily identified.
Generally, there are three types of household expenditure, fixed, variable and
unnecessary expenses. For example, loan, insurance and property management fees
are 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 reserved
at first. Normally the variable expenditures are daily household expenses, such as
clothing, food and utility costs. These are essential household expenses and reflect
the family’s basic living standard, but the amount is adjustable. However this kind of
expenditures 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 a
large sum of money; for example, travel, beauty treatment, entertainment or luxury
goods. To reduce household spending, the most important thing is to control these
expenditures in conjunction with a reasonable target to suit the actual economic
situation.
The third cure: ‘Make the wealth grow’
After saving more than 10% of personal income and cutting unnecessary
expenditures, part of the earnings is kept. Nevertheless, if the wealth growth rate
does not exceed the inflation rate, a decrease in purchasing power will result in a
loss of wealth. In addition, poor investments also reduce hard-won wealth. So
obtaining the steady growth of wealth is the problem that needs to be solved. In
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3. GSBS6150 Individual Financial Planning Trimester3 2011 Student number: 3136767
Student Name: Lei Zhao
Babylon they recognized the extraordinary power of compounding income, to earn
interest by lending money. Furthermore, those who could grasp fleeting investment
were more successful because their wealth increased rapidly due to their excellent
actions and wisdom.
Compared with ancient Babylon, some modern investment theories and financial
instruments 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. These
were by earning interest through lending money or by purchasing property to obtain
rental income. However, in modern society, there is no doubt that there are more
methods available for profitable investment than 6,000 years ago. Modern financial
systems not only include private capital lending and borrowing, real estate sales and
leasing, but also include a highly efficient banking system and various financial
markets such as bonds, stocks, futures, foreign exchange and funds markets. These
financial instruments are still in a continuous stage of innovation and development.
However, along with the growing number of financial instruments, risks are also
increasing. 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 greater
population than in ancient Babylon. Adam Smith (1776) in ‘The Wealth of Nations’
questioned which of the following was growing faster, available profit activities, tools
and opportunities or the population explosion. It is obvious that only the minority can
utilize these profitable opportunities to achieve their rich dreams, although in theory
these opportunities belong to everyone. In the 21st century, investment opportunities
are not obvious and are difficult to calculate with simple arithmetic.
Therefore the ‘opportunity explorers’ have appeared in every market. They have
utilized their wisdom, complicated calculation methods and the most advanced
computers to seek ‘the door of wealth’. They have created some trading models to
limit those risks that result from subjective and non-rational behav ior to achieve an
appropriate risk-benefit ratio. These trading strategies have new names such as
Quantitative Trading, Algorithmic Trading, Program Trading and High-Frequency
trading, 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, he
emphasized fundamental analysis. Afterwards, he set up a company, named
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4. GSBS6150 Individual Financial Planning Trimester3 2011 Student number: 3136767
Student Name: Lei Zhao
Renaissance Technologies Corporation, that relied totally on computer models to do
one hundred percent of the transactions. The business has developed to almost all
tradable and high liquidity markets. The Medallion Fund of the company created in
1988 uses models to predict future movements and capture those fleeting market
opportunities through thousands of daily quick trading, where trading volume could
account for even greater than 10% of NASDAQ total trading volume. In 1990, the
net return of the Medallion Fund was 55.9%, the following year was 39.4%; after
two years were 34% and 39.1% respectively. In 1990, the American Federal Reserve
raised 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 the
Medallion Fund performed well with a net return of 98.5%. As a result, in 2005
Simons became the world's highest-paid hedge fund manager. From 1989 to 2006,
the average annual rate of return was 38.5%, which exceeded Warren Buffett’s
return 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 power
and seize every fleeting investment opportunity, as this is consistent with Arkad’s
third principle of wealth. High-Frequency trading just utilizes more scientific and
efficient investment tools and theories.
Conclusion
The financial wisdom of ancient Babylon is still valid today, as the seven principles of
wealth are consistent with modern financial theories. Situations described in the
prophetic stories of ancient Babylon’s financial principles are still valid today. There
are many methods and strategies to achieve ‘Controlling Expenditures’ and ‘Wealth
Growth’, but these methods and strategies need be learned and applied. Control of
expenditures, even though indiv idual financial statements are completed, continues
to be useless if people cannot effectively cut unnecessary expenditures. For people
seeking wealth, even the best investment approaches do not ensure steady and
rapid growth of wealth because of too much greed and fear. For financial
management, the most essential thing is the use of wise financial habits. When
people have sound financial habits, they can open ‘the door of wealth’ and maintain
it.
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