THE 5 MOST IMPORTANT FINANCIAL CONCEPTS TO UNDERSTAND
If you are in charge of the money for your family here are a couple of concepts that you should understand.
Risk
This is the most important 4 letter word you need to know in finance. There are different types of risk associated with everything you do with your money as well as any type of investment you may make. It is important to understand what that risk is with each.
Everyone assumes risk means the chance that the stock market will go down. That is just one type of risk. You may feel safe by keeping your money in a checking or savings account, but earning 1% interest while inflation is growing at 3% will make you poorer over time. Bonds are another type of investment favored for their fixed interest payments. But with bonds there is interest rate risk. Would you want to have a bond that pays 4% interest if the interest rates go up to 10% and new bonds could provide 6% more interest. Another type of risk is longevity risk. That is the risk that you will outlive your money. Nowadays many people live into their 90's and 100's. If you couple that with the fact that pensions are more and more becoming extinct we have to figure out how to finance our retirement.
Another common misconception is that risk is emotional. Will you be able to sleep at night if your investments went down 5%, 10%, 20%? That is definitely a big part of it, but not the entire picture. It also depends on how much time you have to invest, your future earning potential, and the assets you have that are not invested, such as your home or inheritance.
Compound Interest
When you look at savings and investments which factor do you think has the most impact on how much money you will have? The amount that you save, the investment return that you get, or the amount of time the money is left to grow? All things being relative the time that the money grows will have the greatest impact on savings over the long term.
Here is a chart that shows a couple of savings scenarios. The most interesting comparison is between Susan and Bill. Susan invest $5,000 each year between the ages of 25 and 35. Bill invests $5,000 between the ages of 35 and 65. You would think that at the end Bill would have more money saved since he is saving $5,000 a year for 30 years, versus Susan who is only saving for 10 years, but Susan ends up with about 10% more.
Liquidity
Not all investments are made the same. If you want to sell your house instantaneously you will get a far lower offer than what your house is worth. Liquid investments are those whose fair value can be had at any time of the day. Stock, cash and gold are examples of types of investments that are liquid.
Real Estate and Annuities are two investments that have a liquidity risk associated with them. How easy and how long would it take to sell an investment property you have. It may take 3, 6, or 12 months before you have access to the funds. Or pay the surrender penalty on an annuity because you didn't keep it for 7 years.
If you needed to access $10,000, $100,000 or $1,000,000 how quickly could you obtain it.
Fees and Expenses
As with anything you buy, there are fees and costs associated with investment products and services. These fees may seem small, but over time they can have a major impact on your investment portfolio
Fees typically come in two types-transaction fees and ongoing fees. Transaction fees are charged each time you enter into a transaction, for example, when you buy a stock or mutual fund. In contrast, ongoing fees or expenses are charges you incur regularly, such as an annual account maintenance fee.
It is important that you understand the fees and expenses on every investment you have, whether it is a stock, bond, cd, mutual fund, ETF, annuity, life insurance policy, .... Sometimes it will require you to read through a prospectus or other account/investment documents and sometimes you will have to ask questions.
You don't need to be Warren Buffet or Nelson Rockefeller to be successful with your finances, but it is good to start with the basics like fees and expenses and expand from there.
Inflation
Inflation refers to the sustained increase in the price of goods and services. As prices rise due to inflation, you'll be able to afford less and less. The historical inflation rate is 3% per year.
What's most important is whether your income is rising at the same rate as inflation. If your pay is not keeping up with inflation, you won't be able to afford as much a few years down the road. Or if you are stashing your savings under your mattress or in a savings account that is not keeping up with inflation, you will be impacted in the future.
contribute $5,000 to an IRA, you only pay tax on $95,000. Uncle Sam can provide a nice refund for your contribution.
