Part III · Chapter 8 · Claims · lesson 2
The instruments, through one lens
13 min
Builds on What you actually own
Part III · Chapter 8 · Claims · lesson 2
13 min
Builds on What you actually own
The list of things you can put money into is long, and it gets longer every year as people invent new wrappers for old structures.
The list of underlying structures is short. Six of them cover almost everything, and one set of four questions works on all six.
Four questions, asked in this order, describe any instrument:
Where does the cash come from? Name the human being or organisation whose payment ends up in your account.
Who is ahead of you? When there is not enough, who gets paid first.
What is the worst realistic outcome? Not the average bad case. The one at the end.
What did you give up to hold it? Liquidity, control, optionality, the return you would have had elsewhere.
Before the six, the idea that organises them.
Every enterprise has a queue for its money. Suppliers and staff are near the front. Secured lenders come next, then unsecured lenders, then anyone who was promised a fixed return, and last of all the owners. In a good year the queue is invisible because there is enough for everybody. In a bad year the queue is the only thing that matters.
Your position in that queue determines your instrument far more than the name on it does. Being early means a smaller, more certain return. Being last means everything left over, which is unlimited on the upside and frequently nothing.
A share. Cash comes from company profits, either paid out or reinvested to produce more later. You are last in the queue. The worst realistic outcome is the whole stake, and it happens to individual companies regularly. What you gave up: certainty, and any say worth having unless you own a great deal of it.
A bond, or any loan you have made. Cash comes from the borrower's obligation to pay interest and return the principal. You are ahead of the owners and behind the secured lenders. The worst realistic outcome is the borrower failing and you recovering part of it. What you gave up: any share of the good years — the borrower doing brilliantly does not pay you a unit more than the contract says.
A fund. Cash comes from whatever the fund holds, so the four questions apply to the underlying rather than to the wrapper. You are behind the fund's own costs, which come out first, every year, in every kind of year. The worst realistic outcome is the worst outcome of what it holds, plus the costs of having held it that way. What you gave up: the votes, the ability to hold anything different from the pool, and a fee.
Property. Cash comes from a tenant, or from the rent you avoid paying by living in it. You are ahead of nobody: the lender is ahead of you, and so is every maintenance bill. The worst realistic outcome is a long void with the payments continuing. What you gave up: liquidity, and a great deal of it.
A private business, or a stake in one. Cash comes from customers, through whatever is left after everyone else. You are last in the queue and there is no market to leave through. The worst realistic outcome is the whole stake plus, if you signed for it, more. What you gave up: liquidity, diversification, and frequently your working hours as well.
Cash. No cash comes from it, beyond whatever interest the holder of it pays you. You are an unsecured creditor of a bank, which surprises people. The worst realistic outcome is not a fall in the number — it is the number staying exactly the same while prices do not. What you gave up: any return above the rate, in exchange for being able to act tomorrow.
Predict
Not the same thing
You are owed a fixed amount on a fixed date, and that is the whole of your claim.
You have a claim on whatever remains after everyone else has been paid.
Which is which? Put each one on a side.
A savings account paying a stated rate
A stake in a restaurant a friend is opening
Rent-to-own finance you provided on a machine
A share of the profits of a project, with no promised minimum
Wrappers are not instruments. A great deal of financial product design consists of putting one of these six inside a container and giving the container a name. The four questions cut straight through: ask what the cash underneath is, and the container becomes a cost and a set of rules rather than a thing in its own right.
The same object can be two instruments. Property bought outright is equity in a building. The same property bought with substantial borrowing is a leveraged equity position whose lender is ahead of you — which is why the previous track sat where it did. Nothing about the bricks changed.
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