What Are the Basic Financial Concepts?
The world of finances can be confusing. There are many terms and calculations. Here are five concepts that are basic to financial planning.
What is a compound interest?
When money is invested and earns interest, the initial value will multiply due to the effect of compound interest. The principal value is the initial amount of cash invested. Each month (or other time period) that the principal earns interest, a small amount is added to the original principal and thus a slightly higher amount is now available in the account to multiply over the next time period. Over a period of many years, the effect of compounding interest will significantly grow the initial investment (the principal value). For example, an initial investment of $1,000 that earns 5% interest compounded monthly will have a final value of $1,220.90 after 4 years. This final value consists of two components: the initial principal ($1,000) and the earned interest ($220.90). If left untouched for 25 years, the same initial $1,000 will grow to $3,481.29, due to the compounding effect of interest.
What is inflation?
Inflation is the general increase in the overall price level of goods and services throughout the whole economy. Although inflation is measured for the overall economy, it has an impact on an individual’s purchasing power – in other words inflation impacts your lifestyle since your money does not purchase the same amount of goods and services as in past times.
There are two factors that cause inflation: the perception that people have on the value of goods and services, and the economic principle of supply and demand. The value of money is based on the general perception of the value of an individual currency against another. For example this morning, one dollar ($1) could be exchanged for 125 Japanese yen (125 ¥). This afternoon, the U. S. government announces a policy to allow the value of the U.S dollar to decrease to about 115 Japanese yen. The next day, the value of the dollar would drop sharply, since people (initially investors in the U. S. dollar) believed (the perception) that their dollars would be worth less. The impact on inflation is that now if an American wants to purchase a Japanese-made automobile, it will cost more U. S. dollars to do so, since the dollar does not purchase as many Japanese yen as it did previously.
The second factor that causes inflation is supply and demand, which has a more dramatic impact on inflation. A good example of this effect can be illustrated in the release of a new Apple iPhone. On the day of the release, there is a limited supply of the iPhone and a large consumer demand. Purchasers are willing to pay a high price (and wait in long lines) to get the device. However, a year later, the price of the device will drop (deflation), because Apple has manufactured more of the phones, and the consumer is not as interested in purchasing an outdated model. The government also has an impact on the supply and demand of currency. The U.S. government has the ability to print more dollars (create money) and with more dollars available throughout the economy (a large supply), the value of the dollar could move downward.
What is the time-value of money?
Because the effect of inflation over time causes money to have less value in the future, the concept of time-value of money must be considered. In essence, money held today is more valuable than the same amount of money in the future. Two illustrations can help in visualizing this concept.
If you were to deposit $819.07 in an account bearing 5% interest and left it untouched, in four years it would grow to the value of $1,000. Thus, $819.07 today is equivalent to the value of $1,000 four years from now. From a different perspective, assume that the average inflation rate on the economy over a four year period is 5%. Today, the cost of two months’ worth of groceries to feed a family of four is $819.07. However, four years from now, that same two month supply of groceries will cost $1,000 due to the impact of inflation on the price of groceries. Thus, today’s $819.07 has more perceived value than $819.07 four years from now, since it can purchase more groceries today than in four years.
What impact does risk have on financial decisions?
Risk is the possibility that something bad or unpleasant will happen. With respect to finances, risk is the chance that a particular investment (where you put your dollars) will have a different result than what you expect. Financial risk can be positive or negative. Your investment may earn more than you expected or less. Some financial investments may even risk the entire amount that was initially invested. A fundamental concept in finances is the general relationship between risk and return. An investor will take more risk in his investment if he believes that there will be a chance to achieve a greater return. For example, a U.S. Treasury bond is considered to be a very safe investment. When compared to other bonds, a Treasury bond offers a low rate of return. A corporate bond will provide a much higher interest rate, because there is a greater risk that the corporation issuing the bond may go bankrupt and thus default on paying its bond holders.
What is liquidity of an investment?
Not all investments are the same. Some take a long time to pay a return or are hard to sell to another investor. Cash is the most liquid form of an investment. It is readily accepted by all investors and can be exchanged for goods and services in the general economy. On the other hand, an investment in real estate is very illiquid. Depending on the real estate market in the region, it may be difficult to find a buyer of a piece of property at a fair market value. Real estate is considered illiquid compared to cash, gold or other investments, such as stocks and mutual funds. Liquid investments are those that can be sold in a short period of time at their fair market value.
If you would like more information on basic financial concepts or an individual consultation concerning your financial needs, call a Member Services Advisor at AAFMAA at (800) 522-5221.
John Sledgianowski is an AAFMAA Benefits Advisor.