Want to Achieve Success? You Need to Know these Basics of Finance!
Finance scares many people, and whenever someone’s talking interest rates, futures, bonds, or stocks, they hear a foreign language. However, if you want to retire with a large nest egg and increase your chances of earning more money, then you need to learn the basics. Let’s have a look:
Compounding is a basic concept in finance and which helps you to differentiate between different interest-based investments. Compounding has immense power in finance because it helps you to grow your money over time, earning interest on it. The longer you let your money earn interest, the more you will have in the end, with the money multiplying at an increasing rate over time.
A rule that applies in compounding and which helps you calculate how long you need to double your money with a given interest rate, is the rule of 72. Simply divide 72 by the interest rate you are earning and that is how many years it will take to double your money. For example, if the interest rate you are earning is 3 percent, then it would 24 years until your money has doubled.
Another concept you need to understand is that of inflation. Inflation directly affects purchasing power because it relates to your ability to purchase goods and services over time. So if, after a few years, the inflation rate rises, two things can happen – you will need more money to buy the same goods, or you will have to buy less of it in the same amount. With respect to investments, inflation is important because it differentiates between real and nominal returns. Real returns are inflation adjusted while nominal returns aren’t. So if you earn an interest rate of 1 percent on savings and the inflation rate is 2 percent, your real return will be negative. You will be left with decreased purchasing power. A rule of thumb to avoid inflation affecting your investment negatively, is to earn 3 percent more year on year after tax.
Investments go hand in hand with risk, and with that, there is another important concept in finance that helps you mitigate that risk: diversification. While investing in stocks helps outpace inflation, no financial advisor would ever suggest investing all your money in the same assets. This is called risk diversification. You make a portfolio of investments by choosing a variety of assets to invest in so that any potential loss from one asset class can be covered from another. The varieties of assets available to choose from include bonds, stocks, and commodities, and so on.
These core financial concepts should help you be on your way to investing. It’s not as hard if you practice them in the real world by investing small amounts of money in the beginning and seek more financial knowledge –with more knowledge, come great rewards.