Financial Principles: Four Important Money Principles of Financing and Money Management
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If you could only learn four things about money, what would they be? Read this article to learn about four essential money principles that can help you take control of your finances.
LESSON CONTENTS
Compound Interest
“Compound interest is the eighth wonder of the world. He who understands it, earns it; he who doesn't, pays it.” -Albert Einstein
Compound interest is one of those magical things in life that has the power to create fortunes or tear them down. Compound interest is the interest calculated on the initial principal amount and previous interest, or in other words, interest built on interest.
Compounding interest follows an exponential growth pattern rather than a linear one and can help you get to a savings goal more quickly. Trying to reach a savings goal offers a good, real-world example of the difference between an account with interest versus an account without interest.
For example, if you wanted to save $10,000 and you could save $100 every month, in an account with no interest it would take you about 8.33 years. If you saved $100 per month in an account that gained 5% interest annually, it would take you about 7.15 years. Not only would you have reached your savings goal a year earlier, you also would have gained $1,420 in interest. That means you only had to contribute $8,580.
With compound interest, you can reach your savings goal more quickly and without having to contribute the full amount! The two factors that affect the amount of compounding is time (compounding periods) and interest rates. The longer/more periods your money has to sit and compound, the greater the growth will be. Additionally, the higher the interest rate is, the greater the growth will be.
Unfortunately, the effects of compound interest can be a double-edged sword. While exponential growth can be good for your savings goals and investments, it can be a huge hinderance on any debt you might owe. High interest rates on consumer debt (debt used to purchase things that don’t improve your net worth or that depreciate) can compound over time and if you’re not careful, seriously derail your finances.
Compound interest is a vital part to reaching your savings, retirement and other long-term goals efficiently. Find high yield savings accounts, retirement accounts, or investment accounts to help your money grow and compound.
Remember to:
- Start early and be consistent to maximize the compounding growth.
- Pay attention to how interest compounds on your loans. If you’re not sure, ask your servicer.
- Focus on paying down the loans with the highest interest rates first to save money in the long run.
- Avoid high interest rate loans whenever possible.
Cash Flow
“Making more money will not solve your problems if cash flow management is your problem.” – Robert Kiyosaki
Cash flow management is something that is commonly used in businesses but can also be applied to help manage your personal finances. Cash flow involves the movement (both incoming and outgoing) and timing of money. Some people like to use the term budget synonymously with cash flow, but budgets tend to be more static and don’t account for timing issues.
The basic concept of cash flow management is that the system doesn’t work if you have more money going out than coming in. If you have more money going out on a monthly basis than you have coming in, that’s called a negative cash flow. If you have more money coming in than going out, it’s called a positive cash flow.
The fluid nature of your personal cash flow on a month to month basis makes planning and tracking a challenge. Luckily, there are a lot of technology resources that you can use to help you keep track of everything. Credit unions, banks and credit card providers usually have a mobile app with features that help categorize and track your spending. If your financial institution doesn’t have some form of app or online banking tool to help with this, you can use a third-party budgeting or personal finance app. These usually allow you to aggregate your different accounts into one platform to consolidate your cash flows and make tracking easier. It is recommended to review your cash flow activity twice a month to allow you to adjust your spending, make any necessary transfers, or to prevent timing issues.
Timing issues can occur in between your pay periods. If you look at a monthly budget, you may think that you make enough money every month to cover all your expenses. However, it’s possible that, especially if you have automatic payments set up, your expenses may be deducted from your account before your paycheck comes in. This can lead to a build-up of unnecessary overdraft fees. To help combat this, pay attention to the different services you have monthly subscriptions for. They can add up and it’s easy to forget about them if you stop using the service.
The overall goal of personal cash flow planning is to create what’s called free cash flow (FCF). FCF is cash that is not being used to pay for expenses, or in other words a surplus of income. It can then be used to fund things that build your assets such as a rainy-day fund, putting extra money toward paying down a mortgage or credit cards, saving for retirement, or saving for a trip.
Remember to:
- Use technology to help track your cash flow.
- Break down your expenditures by category, then focus on reducing spending on a single category every month.
- Ask your credit union, bank, or other financial institution what tools they have that help manage your money on a day-to-day basis.
Opportunity Cost
“Intelligent people make decisions based on opportunity cost.” – Charlie Munger
Most people don’t have an infinite amount of money to work with and must at some point or another, choose one financial priority over another. Maybe you have Goals A and B, but not enough money to fully contribute to both. You can either put 100% or your extra money into either choice, or fund Goals A and B at 50%, respectively. Whichever route you choose, there will be some form of missed opportunity or benefit.
This is the idea of opportunity cost, which is classically used in economics. Opportunity cost refers to the potential benefit or gain lost when one alternative is chosen over another. We face decisions every day that have opportunity costs where we must weigh the pros and cons of each option. If you learn how to think about the opportunity cost of financial decisions, you’ll be able to better allocate your money and meet your goals even with limited resources.
Opportunity cost decisions are usually driven by limited resources and balancing of financial goals. These goals usually fall into two opposing categories such as prioritizing long-term or short-term goals or paying off debt versus saving for the future.
One of the more common opportunity cost scenarios that young people face is deciding whether to put more money towards paying down their student loans or using it to start investing/saving for retirement. Young professionals in the beginning of their career generally have fewer financial resources and must decide if it will be more beneficial to focus on paying down debt or starting to invest for the long term.
When comparing the opportunity cost of each choice, you have to look at the potential benefit that would be lost. In this scenario, a person should see how much they would save in interest payments by putting more money towards the student loans versus how much money they would accrue by starting to invest. Choose whichever option better suits your goals, personality and has a greater impact on your net worth (value of total assets – total debt/liabilities). You can also use the interest rates to help guide your decision. If you have extra money to spend and are trying to decide where to put it to meet your financial goals, you generally want to allocate more money to the choice that has a higher interest rate or rate of growth.
Remember to:
- Think about things over the long term, which option is most impacted by time? In most cases, capitalizing on the time value of money is the most important factor.
- Compare annual percentage rates (APR) and annual expected returns. Does one outpace the other?
- Which option has the greatest impact on your net worth? Use calculators for future value and interest payments.
Diversification
“Diversification is a protection against ignorance.” – Warren Buffet
When most people think about diversification, they think about the stock market and investing. You might remember something about diversification being brought up when talking with a financial advisor, or when sitting in a class learning about your company’s 401(k).
Diversification is a strategy that helps lower risk and the chance that you would have catastrophic losses. In simple terms, it’s making sure all your eggs aren’t in one proverbial basket. By diversifying, or allocating your money in different categories, you are protecting yourself from losing all your money due to unknown/unforeseen circumstances.
As we previously mentioned, most people think about diversification in association with investments and diversifying into different asset classes, but diversification can also apply to other personal financial matters. One example would be the diversification of income sources. If you have a job with a salary, you have a way of gaining income if you can work. If you have a side hustle or a passive income source like a rental property, you’re creating an income stream even if you don’t have your job. You might have disability insurance that provides income in case you get hurt. But it’s beneficial to review multiple scenarios to make sure that you’re properly diversified and protected whether you’re planning income sources, investment allocations, or other financial goals.
Remember that diversification, at its core, is a way to protect yourself if something unexpected happens. To be properly diversified, you need to have allocations that are not correlated, or don’t behave in the same way in the event of a different scenario. For example, a side hustle or passive income stream gives you income diversification because you can still receive money even if you lose your full-time job. However, if you lost your full-time job and that adversely affected your side hustles, then you wouldn’t be diversified.
Diversification falls on a sliding scale. The more dissimilarly the asset classes or categories behave in the same scenario or situation, the more diversified they are. How diversified you are should depend on your risk comfort, your level of expertise within an asset class and your time horizon for your goals.
Remember to:
- Think through different scenarios: do your financial assets behave the same way? The degree to which they do or do not shows how diversified you are.
- Consider how different financial products diversify your income streams. Your job provides income while you can work, investments can provide income when you retire and insurance can provide income if something bad happens.
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