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Ethical Investing is BAD Investing... Here's Why - How Money Works - YouTube
Channel: How Money Works
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Ethical investing has become incredibly popular
in recent years.
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The promise of being able to put your money
towards businesses that don’t harm the environment,
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exploit vulnerable workers, or engage in bad
business practices is obviously very attractive.
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The idea of this practice is that by denying
these bad companies access to investment,
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they won’t have the opportunity to grow
and continue their harmful practices.
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Some big names in the investment space have
also backed up an ethical investing strategy
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by saying that not only will it do good for
the world, but it will also do good for your
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wallet, because it can offer higher returns
than a traditional investment strategy.
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The problem is that… it almost certainly
CAN’T.
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Ethical investing may feel good but under
the surface it effectively rebrands one of
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the biggest mistakes that people are make
when getting into investing, not being diversified…
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What’s more is that ethical investing might
not actually have the positive effect on the
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world that you might initially expect from
listening to the thought leaders in this space.
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So it’s time to Learn How Money Works and
find out why ethical investing is bad investing.
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As with many of my other more controversial
video’s that might not necessarily tell
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people what they want to hear, this was made
possible by the generous support of my channel
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members and patrons on patreon.
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If you want early access to video’s and
an extra video every month please consider
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supporting the channel on either of these
platforms…
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Alright, so before I start ripping into ethical
investing it’s important to understand how
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it actually works.
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When investors talk about ethical investing
they are most often talking about ethical
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investment management funds or ethical index
funds.
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Popular examples of which include Chamath
Palipatiya’s Social Capital, as well as
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large selection of publicly traded indexes
from companies like BlackRock and Vanguard.
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Now actively managed funds have their own
problems, multiple studies have shown that
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after management fee’s only a teeny tiny
percent of them consistently outperform the
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market so already they are not off to a great
start.
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But to keep things fair I want to park those
types of investment companies to the side
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for this video and focus just on the ethical
index funds.
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These are far more likely to be used by regular
investors and they also make up a far larger
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share of the market.
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We are also going to ignore the associated
fee’s on these funds, which are normally
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substantially higher for the ethically branded
variants, so trust me I really am trying to
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give them a fair go her.
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But with that out of the way the first thing
you need to know is how are these indexes
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made?
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Well like all index funds ethical indexes
are made up of tiny slices of lot’s of different
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securities.
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These thin slices will then be bundled up
into an index and sold off to regular investors
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as a totally new security with inbuilt diversification.
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This is amazing for most investors because
diversification is just SOOO important when
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building out a portfolio, but it can also
be prohibitively expensive.
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To buy a capitalisation weighted share of
every stock in the S&P 500 would cost hundreds
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of thousands of dollars.
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Some individual shares themselves can be worth
more than an average person’s entire portfolio
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so index funds like the SPY are a much more
suitable alternative.
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Ethical index funds work basically the same
way, but they only let ethical slices into
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their index pie.
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There are two ways they can do this, the omission
method or the inclusion method.
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The omission method is the most common and
it involves investment companies starting
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with a base index of lots of companies and
then kicking out companies that operate in
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certain industries, perhaps fossil fuels and
tobacco companies.
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This works well but there are inevitably some
bad players that will fall through the cracks.
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Nestle is a snack company so it wouldn’t
be omitted from this index despite not exactly
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being what you might call a shining beacon
of moral virtue.
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This is where the inclusion method is preferable.
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This is where investment companies will individually
pick and choose companies that adheres to
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their ethical framework.
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Generally speaking inclusion funds will be
filled with companies that really are trying
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to make the world a better place and omission
funds will be mostly filled with companies
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that aren’t completely terrible.
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So now that you know what goes into creating
these funds, you might think this still sounds
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pretty good, and that’s why it’s time
to learn about the two big reasons why they
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are not…
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…
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The savvy investors amongst you may have already
picked up on the first major problem when
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looking at how these funds were made which
is that by one means or another there is some
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system actively selecting stocks.
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The more you pick and choose your stocks the
less diversification you will naturally have
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which is a really bad thing.
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To demonstrate why, consider a casino filled
with lots of tables all offering various games.
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For the sake of this example lets say on average
that these games have a house edge of 10%,
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which means for every 1 dollar you put into
a game you are expected to make just 90 cent’s
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back.
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To keep it even more simple imagine one of
these games is the simple flip of a coin.
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If you lose the flip you give up any money
you bet on that hand, if you win the flip
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then you win one dollar and eighty cents maintaining
the 10% house edge.
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Obviously this is unfair, but it’s effectively
how all gambling works, it’s normally just
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a little bit less obvious.
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Ok, so as a player, how many flips of a coin
would you bet on to maximise your expected
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return?
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The correct answer is none, or if you are
forced to you want to be on a little as possible.
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If you bet on one flip sure you might lose
it all then and there, but you have at least
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a 50% chance of making some money.
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Statistically speaking it only goes downhill
from there.
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If you don’t believe me I have linked a
Monte Carlo simulator in the video description
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so feel free to play around with it.
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Alright now let’s flip this example on it’s
head.
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What if you were the casino manager?
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How many games would you want people to play
to maximise your potential return?
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You would want them to play as many as possible.
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A player that comes in and drops a bucket
of money on a single hand is actually very
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scary to a casino because that player has
an almost 50/50 chance of walking away with
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double their money.
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If a player instead decides to split their
money up and play over 50 hands they are almost
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guaranteed to loose money.
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This is why if you ever go to Vegas you will
notice that most card games have table limit’s
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to spread out people’s gameplay and give
the odds time to do their thing.
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Now replace casino with stock market.
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The American stock market has historically
returned around 10% per year so that means
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if you are an investor, you are in the fortunate
position of having the house edge.
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Of course, you could put all your money on
a single hand or a single stock and generate
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massive returns in a very short period of
time, but with the house edge you are (statistically
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speaking) better off spreading out your money
as much as possible to let the odds do their
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thing.
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Now this makes a few assumptions, you could
have insider knowledge or be a card counter,
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but both of those strategies are going to
get you kicked out of the respective example
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very quickly.
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What this means for our ethical ETF’s is
that they are intentionally forgoing the inherent
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benefit that comes from playing as many hands
as possible, and what’s worse is that they
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are often omitting entire games all together.
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Let’s say that tomorrow large lithium ion
batteries were shown to give people cancer.
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This would be devastating for electric vehicle
companies, but it would probably be great
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for the fossil fuel industry.
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In theory a well-diversified portfolio would
have exposure to both of these industries
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and the losses in the former would be mitigated
by the gains in the latter.
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If you were only exposed to the more ethical
industry, you would feel all of this pain
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directly.
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You may personally believe that ethical businesses
are the future, and I hope your right, but
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that is a belief, it’s a speculation…
good investors don’t speculate…
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…
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Alright, now what if you have taken all of
this on board and are still happy to deal
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with a slightly lower return in order to do
your part for the good of humanity?
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Well there is still a better way, because
beyond everything else, ethical investing
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probably doesn’t do that much good at all.
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Almost every stock that is purchased to make
up these ethical funds will be purchased from
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the secondary market.
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That is shareholders that already owned the
stock and are now selling it, rather than
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the company itself.
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That means that money invested into tesla,
isn’t going to fund new electric cars, more
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than money invested into BP is going towards
setting the world on fire.
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The money is just going to the random investor
that owned the shares before you.
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Now these is one counter argument that ethical
proponents will use to dismiss this critique
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which is that company managers have an obligation
to maximise shareholder value, if their morally
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tainted shares become so unpopular that the
value tanks then the management will be forced
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to change up operations or risk being thrown
out by the board.
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This idea is nice in theory, but here is what
will actually happen, let’s say an investment
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fund decides to go ethical and dumps all of
their oil and natural gas holdings.
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The price of these shares take a beating after
the selloff but now they represent a better
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value to morally indifferent investors.
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If this happens enough then sure the share
value of a company might plummet but that
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only makes it more popular amongst buy and
hold investors who might start getting a 5,
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10 or even 15% dividend on their newly discounted
stock purchase.
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This increased earning per share will drive
demand and counteract the effect of the ethical
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selloff in the first place.
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For better, or for worse, people engage in
the stock market to make PROFITS.
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Going in there with an ulterior motive (however
noble) is going to put you at a big disadvantage.
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If you really do feel passionately about these
issues that’s fantastic.
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honestly, I am right there with you.
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But ethical investing is just not the right
way of going about pushing change.
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You would be far better off investing wisely
and using your extra profits to donate towards
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the causes you believe in, or even purchasing
products from companies that you believe are
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doing good.
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Ethical investing might give you the warm
fuzzies, and I am sure there are going to
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be a million comments in the comments section
talking about how XYZ index returned 20% last
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year, but that’s all missing the point…
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If you want to invest wisely, you need to
respect the statistics, one index generating
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great returns over a year or two is no different
from a gambler on a lucky wining streak.
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If you want to invest your money, invest well,
if you want your money to do good for the
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world, spend it in ways that do good for the
world, don’t become an ethical investor
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and expect to be the saint of wall street,
because it’s just not the way it works.
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Now if you want to learn about another type
of scheme promising to mix financial gain
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with moral virtue, go and watch my video on
the dark secret behind those Omaze giveaways
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you have likely seen sponsored all over YouTube.
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A big thank you again to all of my amazing
patrons and channel members for making it
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possible for everybody to keep on learning…
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How Money Works.
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