Personal finance is a term that covers the planning and managing of one’s personal financial activities such as budgeting, saving, insurance, debt management and retirement planning to name a few. Under this discipline there are a few key concepts that must be defined and understood in order to get a better handle of your finances.
In an effort to demystify some of these concepts, I will take the time to describe them in simple relatable terms that everyone can understand. This is not a comprehensive list and more concepts will be covered in future articles.
Inflation is when the price of goods and services increase steadily over time, consequently increasing your spending over time as well. It is a fact that if you went to the store today with N$100 you would afford less items than you did in 2015. This is evidence of inflation at work.
This steady increase in prices is caused by numerous factors, such as an increased demand for goods and services, increased wages, increased input costs, and increased transport costs. While this affects how much money we spend over time on basic goods like bread and milk it also has a negative impact on our savings.
In relation to savings, inflation reduces the value of money saved over time, which is why people opt to put their money in savings and investment vehicles that can earn returns above inflation. Since inflation reduces buying power, it has a direct effect on how much money you would need to maintain your standard of living. For example, if you have N$1000 in a savings account that pays 5% interest per year, after a year you would have N$1050. If inflation is 2% your money has only truly grown by N$30 because the other N$20 has been eroded by inflation.
Anytime your savings or investments do not grow at the rate of inflation or higher you are effectively losing money.
It is imperative to clarify that interest can be paid to you (through savings and investments) or you can be the one paying the interest (through loans). Compound interest is one of the most important concepts to understand when managing your finances. It can help you earn a higher return on your savings and investments, but it can also work against you when you’re paying interest on a loan.
Compounding is the process of increasing something by adding it to another. Investopedia describes compound interest as: “the process of generating earnings on an asset’s reinvested earnings”. In other words, compound interest lets you earn returns on previously reinvested money by adding the interest earned back into your principal balance, which then earns you even more interest, compounding your returns. From an investment point of view compound interest is magic because you earn interest on interest, your money creates more money.
Compound interest accelerates the growth of savings and investments over time. Conversely, it also inflates any debt balance you owe over time. If you’re borrowing money, compounding works against you and in favour of the lender instead. You pay interest on the money you’ve borrowed; the following month, if you haven’t paid, you owe interest on the amount you borrowed plus the interest you accrued.
Diversification is a technique used to allocate resources to a mix of different investments. The ultimate goal of diversification is to reduce the volatility of the overall portfolio by balancing losses in one asset class with gains in another asset class.
When using diversification techniques in our own portfolios the goal is to have different types of assets, with dissimilar risk levels, in various industries and across geographical boarders. That way, if one asset class isn’t doing well, others within the portfolio can balance it out. The reasoning behind this is that assets classes behave differently during bull and bear markets. A well-diversified portfolio should withstand this volatility without substantial losses.
Although diversification does not completely eliminate the inherent risk that comes with investing in financial markets as a whole, it creates a hedge against market volatility.
These are just the fundamentals of understanding this vast subject matter. Take some time to understand the above concepts and you will never be left wondering what they mean and how they are relevant to your life again.
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