What are financial concepts, exactly? Financial concepts are the principals we all need to understand in order to manage our money effectively. They are essential to financial literacy and act as the backbone for all our wealth-building decisions. So without further ado, here are the 8 financial concepts every adult should understand.
1. Net worth
Your net worth is one of the most important metrics which can help you quantify and track your financial health. Net worth is equal to your assets minus your liabilities. Simply put, it’s the value of what you own (assets) minus what you owe (liabilities).
Net Worth = Assets – Liabilities
It represents your total financial value as an individual or family. To state the obvious, the goal is to grow your net worth over time, by increasing your assets and decreasing your liabilities.
Why should you care about your net worth?
There are a lot of numbers involved in personal finance – credit scores, loan balances, interest rates…the list goes on. Tracking and comparing each and every one those individual numbers and accounts would be a tremendous amount of work.
Your net worth ties everything neatly together in a single number – most easily managed through an app – which makes it easier to actually track whether or not you are making progress towards your goals. You can easily see movement in your net worth as you increase your assets and decrease your liabilities.
A second very closely linked financial concept to net worth is liquidity, also referred to as liquid net worth. Liquidity essentially sums up how much money you would have at your disposal with little to no notice. In other words, how accessible is your money? The calculation is very similar to the equation used for net worth, however you only account for your liquid assets.
Liquidity = liquid assets – liabilities
Liquid assets include cash and anything that can quickly be converted into cash without losing value. Common liquid assets include things like cash and the balance of your checking and savings accounts. On the contrary, common non-liquid (or fixed) assets include your home, retirement accounts, etc.
Why should you care about your liquidity?
If all of your money were to be tied up in fixed assets, it would be extremely difficult to handle any unexpected life events. Whether you may need money quickly for an emergency, loss of a job, or to be able to invest in an unforeseen opportunity, having a degree of liquidity is essential.
The important thing is to determine a reasonable degree of liquidity. You don’t want to have too much cash or cash equivalents just lying around. It’s best to keep your money working for you as much as possible. But it’s important to have enough liquidity to cover your necessities if and when the time arises.
Inflation is the decrease in purchasing power of your dollar (or any unit of currency). It’s measured by an increase of the average price of goods and services over time. What does that mean exactly? You’ve likely heard your grandparents reminisce about the good old days when a gallon of milk only cost 83 cents…
In this example, the price of a gallon of milk slowly increased with inflation from 83 cents per gallon in 1950 to $2.90 per gallon in 2018. Back in 1950, your dollar would have had much higher purchasing power (meaning you could buy more milk) than you could in 2018.
Before you begin thinking that inflation is all bad, here are some things to take note of. Moderate levels of inflation are actually considered to be a positive economic force. While inflation causes the purchasing power of your dollar to decrease, it also acts as a positive economic force by incentivizing spending, investing, and borrowing. However, inflation rates that exceed moderation can be dangerous to individuals, businesses, and economies alike.
Why should you care about inflation?
It’s important to understand how the value of your money changes over time. The long-term (1919-2020) average annual rate of inflation hovers around 3%. Over that 101 year period, there were certainly years where inflation was higher, and others where inflation was lower. But, in general, a 3% rate of inflation means that your dollar loses purchasing power by roughly 3% each year. In other words, your $1 would be worth only 97 cents next year, and only 94.09 cents the following year, etc.
This is important to understand in order to make smart earning, investment, and saving decisions. For example, if you haven’t gotten a salary increase at work for the last 5 years, it is essentially equivalent to taking a 3% pay cut for each of those years. And as for investment and savings decisions, you’ll want to put your money into accounts and invest in assets that can effectively counteract the impact of inflation.
4. Time value of money
The time value of money is a financial concept that explains how money that you possess now is worth more than that same sum of money in the future. Simply put, the earlier you have money available to you, the more it’s worth.
Why is that? If you’ve read even a few articles here at The Ambitious Dollar, you know we love to echo the sentiment, “make your money work for you”. The time value of money concept explains exactly that. The more time you have to put your money to work, the larger it can grow. With time at your disposal, you can invest that money and/or accrue interest allowing the value to increase.
Why should you care about the time value of money?
This financial concept is incredibly important as you make monetary decisions. Sometimes it’s a simple matter of being organized and intentional. Other times you may need to harness your willpower through delayed gratification.
For example, maxing out your annual retirement contributions within 6 months, rather than spreading it out over the course of the year will give you an additional 6 months of earning potential. Or maybe it’s finally choosing a side hustle to set up a passive income stream for yourself rather than putting it off for another year. Whatever your situation, make sure you account for the time value of money in your financial decisions.
5. Risk tolerance
Investment risk is the possibility of not realizing the expected returns on your investment. That may mean you expected a return of 12% on your investment, and instead you only received a return of 7%. It could, of course, be much worse. You could see no return or even a negative return which would leave you with less money than you started with.
Risk is an important concept to acknowledge in investing. Investors need to understand that all investment decisions incur a degree of risk. Even the ‘safest’ investments have risk in the form of opportunity cost (more on that later).
Risk tolerance, then, is the level of risk you are comfortable with.
Why should you care about risk tolerance?
If you aren’t honest about your risk tolerance, it can lead you to make some poor choices, which may even increase your overall risk. Risk tolerance is influenced by many factors including your emotions, investment horizon, future earning potential and liquidity.
It is essential to make investment decisions that align with your risk tolerance. Your risk tolerance can change over time, and your investments will likely change alongside it. But if you do not align the two, you’ll likely pay some consequences. In the best case scenario, you may increase your stress level as you start to doubt, worry, and fixate on the possible negative outcome. In the worst case scenario, you may lose your investment, or even more, if you make subsequent choices which incur penalties and fees.
Interest is a two way street. It can work for you, and it can work against you. It is essentially a percentage fee paid to the lender and charged to the borrower. For example, you may receive a small interest payment for the balances in your checking and savings account. Typically your bank (the borrower in this example) will pay you (the lender) interest on the balance of your accounts. On the contrary, when you take out a loan, you will pay interest (as the borrower) which you pay to the bank (as the lender).
Why should you care about interest?
Interest can be a sneaky cost when it comes to borrowing money. You will pay interest for as long as you have any debt owed – credit card debt, automobile financing, etc. So the longer you owe money, the more interest you will ultimately pay. This is why it’s important to focus on the total amount owed and the interest rate rather than just ensuring you can meet the monthly payments. Simply focusing on the monthly payments won’t make it easy to see how much you’ll be paying in interest vs. principal.
7. 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, as opposed to simple interest, allows you to accrue interest on both your principal investment and the accumulated interest. Let’s look at an example.
Simple interest version
Say you’re investing $10,000 at a 7% annual interest rate for 5 years. Your investment would earn a total of $3,500 in interest. This would bring your entire balance to $13,500 ($10,000 principal + $3,500 in interest).
Compound interest version
If you invested that same $10,000 at a 7% annual compounding interest rate for 5 years, you would accrue $4,176.25 in interest. That’s an additional $676.25 you’d make in interest purely because of the compounding effect.
The compounding effect becomes even greater on longer timelines. If we used the same example above but instead invested the money for 30 years, you would earn an additional $50,164.97.
Why should you care about compounding interest?
We’ve said it already and we’ll say it again. The more you can make your money work for you, the less you’ll have to work for money. Compound interest is a game changer in that endeavour.
8. Opportunity cost
Opportunity cost is the financial concept which shows us that every choice we make causes us to lose a potential gain from an alternative choice. For example, you may opt to quit your job and go back to school because you’ve determined you’ll make an extra $10,000 per year with a higher degree. In making that decision, one of your opportunity costs is the money you would have made at your current job instead of quitting to go back to school.
Opportunity cost is representative of the fact that every choice has tradeoffs. No decision will ever be entirely perfect. Opportunity costs may be small, or they may be large, but they exist with every choice we make.
Why should you care about opportunity cost?
Understanding the opportunity costs associated with particular decisions will help you determine the best course of action. When you’re evaluating whether or not something is ‘worth it’, you’ll have a more full picture of what you’re gaining and losing in a situation when you account for opportunity costs.
If what you can expect to gain is greater than what you can expect to lose, then you should pursue that option. However, if one particular choice looks very attractive in and of itself, but less attractive (i.e. “not worth it”) when you account for the opportunity costs, then you should most likely make a different choice.
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