Americans fail when it comes to financial literacy. For example, 44% of Americans don’t have enough cash to cover a $400 emergency. Now who’s to blame… the government, school systems, or parents? I’m not going to point any fingers. Instead, I think it’s more important to focus on what we can control. You can learn – or brush up on – a few of the top financial concepts below and share them with others.
For a series of financial exams I studied over 6,000 pages. That’s not including my double major in Accounting and Finance. But don’t worry, you don’t need to slog through all that study material. I’ve boiled down some of the most useful financial concepts.
On this page, you’ll find 16 concepts that are vital to building and keeping wealth. And to start, let’s first visit the idea of money…
1. Money isn’t Evil
Some people think money is evil. That’s a misguided belief. What some people do for money can be evil. But that’s an inherent problem with any monetary system.
Money is simply an intermediate for the exchange of goods and services. It’s an unbiased measuring stick that tends to gravitate towards where it’s treated best. This is a core financial concept that everyone should know.
As a consumer, you want to get the most value per dollar you spend. And on the other side, businesses want the same. When hiring employees, they will pay a higher wage when workers add more value… so I hope this new trend catches on, saying “going to add value” instead of “going to work.” It’s a powerful mindset that can help you focus on finding ways to add value rather than clocking in and out for a paycheck.
2. Value is Relative
Learning how to value what you buy is important. And people value things differently. This is clear at auctions with live bidding… but it’s harder to see in other markets. So look past the surface. Do your homework and use history as a guide to help you determine value.
When it comes to investing in stocks, I see too many people focused on the share price. Instead, they should look at the underlying company. They own a piece of the business. Here are some wise words from one of the world’s best investors…
Whether socks or stocks, I like buying quality merchandise when it is marked down. – Warren Buffett
3. Supply and Demand
Supply and demand is a basic economic concept. But it’s vital to keep in mind. When demand outpaces supply, prices tend to go up and this works in reverse. This concept also goes hand-in-hand with determining anything’s value.
To better predict where prices are going, you can estimate future supply and demand. This is where financial analysts focus most of their time in the commodity sector. Will a dry summer lower soybean yields (supply)? If so, and demand stays unchanged, buy soybean futures.
This financial concept is also used against you when some companies sell products. They create perceived scarcity. Many companies will list a “limited” number of products or spots remaining. It makes the sale seem more urgent. Keep an eye out for it and save yourself some money. Try to take more time to decide if it’s a worthwhile purchase.
4. Active vs. Passive Income
The money you make from working is active income. And active income is limited by the demand for and scalability of your job. For example, some doctors can only help 10 patients a day… but a developer can create software that helps millions of people. So that’s more scalable.
Passive income is a result of putting your savings and other assets to work for you. For example, collecting rental income can be passive… although it’s not my top choice. Instead, I’m a big fan of investing in dividend stocks.
To retire comfortably, the goal is to replace active with passive income. This can help you reach financial independence. I’m working and investing to achieve that by age 35. It’s a lofty goal but if I fall short, I’ll still be much more financially sound.
5. Delayed Gratification
Humans have developed to seek short-term gratification in many areas. That’s why obesity and high levels of debt run rampant. Saving for a rainy day isn’t a fun choice today… but it can lower stress later.
You can take out debt and buy fancy things… or wait until you have the cash saved up. When you have more cash saved up, you can often get better deals on big ticket items like a car or house.
Delaying gratification is a powerful concept that’s not easy to follow. But once you see the positive effects, it becomes easier to postpone purchases and put in the hard work upfront. It’s mind over matter.
6. Interest Works for or Against You
When you take out debt, you end up paying more. The lender provides you a service by letting you borrow their money. And to compensate the lender, you pay interest… but the interest eats away at your net worth.
It makes sense to take out debt and pay interest in a few cases. For example, if you know what you’re doing in real estate, you can leverage up. But 95% of the time, people should avoid taking out debt like the plague. Instead, you can save, lend your savings, and collect interest. To become – and stay – wealthy, you should put your savings to work.
7. Compound Interest
Compound interest is a vital financial concept. It goes hand-in-hand with others on this list. In a nutshell, it’s when you earn interest and then put that interest back to work. Your savings grow at a faster rate the longer you let them grow.
For example, if you invested $100,000 at an annual rate of 5%, you’d collect $5,000 in interest each year. After 10 years, you’d have collected $50,000 in total interest… but if you reinvested the interest each year, you’d have $62,889 in interest. In 30 years, the difference is $150,000 vs. $332,194. And in 50 years, it’s $250,000 vs. $1,046,740. Your savings compound!
Compound interest is the eighth wonder of the world. – Albert Einstein (often attributed to)
8. Focus on Return AND Risk
You’re more likely to hear about people winning big than their big losses. This skews reality. People focus too much on potential returns and fail to factor in risks. But measuring risk is just as important.
To measure risk, volatility is widely used. How fast does an asset’s price change in the market? Bitcoin is a prime example of a high volatility asset. It could be up or down 10% in any given day. On the other hand, government bonds are lower risk. The prices don’t move around as much so it’s easier for investors to forecast returns. And generally, the higher the risk, the higher the return. This is one of the top financial concepts.
Risk is also different depending on your timeframe. Stocks are risky in the short-term, but in the long-term, it’s more risky if you don’t invest in stocks.
9. Lower Your Fees with a Passive Approach
Fees eat away at your returns. They also compound over time. If an asset manager charges you 2%, that could easily result in over $100,000+ in fees over your lifetime. On top of that, active managers tend to under-perform a passive approach.
Instead, you can buy low cost, passive index funds. Vanguard is a top choice for many intelligent investors. The Vanguard S&P 500 ETF (VOO) has an expense ratio of 0.03%. That’s hard to beat.
10. After-Tax Returns
Uncle Sam needs his cut of your income to keep our country afloat. But you shouldn’t pay any more than you are legally required to pay. There’s a big difference with tax evasion and avoidance. Tax evasion is illegal and avoidance is not.
I helped with a program called Volunteer Income Tax Assistance (VITA). I know from firsthand experience that the tax system is a mess. There are well over one million words in the tax code. And a tax professional can be worth their weight in gold. But that’s for more complex situations.
For individuals, contributing to a 401k, IRA, and HSA can save you thousands of dollars each year. Use them to your advantage. Also, not all income is treated equal. Passive income – like dividend income – can be taxed at a lower rate than active income.
11. Inflation is a Hidden Tax
A dollar today isn’t worth a dollar from 1950. For example, a new car cost $1,510 back then and a men’s wool suit ran for $28.90. And today, a new car will cost you over $25,000 and a new suit over $200. It’s easy to see the impact of inflation over the long-term… but it still chips away at your spending power each year.
It’s good to keep some cash on hand for emergency expenses… but keeping too much isn’t ideal. After the great depression in the 1930s, people lost trust in banks and stuffed money under their mattresses. But as a result and after deflation reversed, their true wealth dropped over time. This is one of the most important financial concepts that many people overlook.
12. Opportunity Cost
You have opportunities all around you. But your time and resources are limited. Learning how to allocate them is important to building your wealth.
To do so, you must determine your short and long-term goals. With those in mind, you can better choose the opportunities that will help you reach them. Opportunity cost is the benefit that you miss out on due to choosing one alternative over another.
When I walk in for a job interview, I’m rarely nervous about the interview. I’m more nervous about if I’m offered – and accept – the job, then what other opportunities will I miss? Opportunity costs can run high but you can limit the impact by weighing your options.
13. Sunk Cost Bias
Have you ever read half of a book, realized it’s not worthwhile, and finished reading it anyway? If so, you’ve fallen prey to the sunk cost fallacy.
Sunk cost occurs when you’ve spent time or money on something that you can’t recover. Those past efforts then keep you around. This happens in finance when investors keep throwing money at a losing investment. So it’s always good to revisit your current set of opportunities and don’t overweight sunk costs.
Psychology plays an important role in your finances. You can find more psychology concepts in my CFA Level 3 Behavioral Finance notes.
14. Lifestyle Inflation
When most people inherit money or get a raise, they increase their expenses in tandem. Even worse, some workers spend bonuses before they receive them. This is lifestyle inflation at work.
With more income, your wants become a reality. You can go out more and buy new toys. But in most cases, people buy things they can easily do without. In time, some of the new toys and services start to feel like needs. If your boss fires you or emergency expenses come up, you’ll need to cut back and it doesn’t feel good.
That’s why I’m urging you to avoid lifestyle inflation. Don’t spend all of the money you earn. Save a little and it can prevent financial hardships down the road. Financial stress causes family issues and can hurt your health.
15. Emotional Intelligence
Emotions can be useful, but more often than not they lower objectivity and lead to worse outcomes. That’s true for relationships, work negotiations, driving (think road rage), and many other areas of life. Understanding the impact of emotions can help you make better financial decisions.
When investors trade often, they’re more likely to make emotional decisions. This is one reason that short-term traders tend to under-perform long-term investors. The short-term trading impulses also tend to overlook the impact of fees.
In several studies, women outperformed men in investing. The studies covered millions of investor accounts. What they found is that women trade less frequently. A buy-and-hold investing approach lowers emotional trading.
16. Diversification is a Free Lunch
Don’t put all of your eggs in one basket. If you diversify your portfolio, you can lower your risk adjusted return. This is sound financial advice but some investors point out this popular quote…
Diversification is protection against ignorance. It makes little sense if you know what you are doing. – Warren Buffett
That’s true at face value but if you look a little further, you’ll see that Warren Buffett accepts his ignorance. He’s invested in railroads, candy companies, banks, tech firms, food processors, etc. Putting your life’s savings into one company or sector is too risky. To put it in perspective, if you lose 90% of your investment, it takes a 900% gain to reach break-even.
Diversification can lower downside swings. So I will continue to hedge my ignorance just as Warren Buffett and other great investors do.
Financial Concepts Final Thoughts
If you master some of the financial concepts above, you’ll lead a more productive life. I’m personally using many of these concepts. They’re helping me make great strides to becoming financially free. I’m taking steps to reach financial freedom by age 35.
What concepts above do you use in your life or think about often? Do you have any ideas to add? Also, if you enjoyed this article, I’d appreciate it if you share it with friends 🙂
P.S. Like financial data and trends? Check out six indicators the are pointing towards a Stock Market Crash in 2020.