Most people understand just enough about finance and money to get by. But according to finance insiders like Dan Schatt and others in the industry, there are some very basic money concepts that most people don’t fully understand.
There’s a pretty wide range of knowledge and financial literacy out there, so we’ve identified ten critical concepts about money and finance that we think everyone should know before they become adults. If you like to keep your finances simple, or if you’re just starting out in the world of money, understanding these ten concepts is a good place to start.
Saving versus Spending
The classic example of someone who can’t save versus someone who can is a person with $2 and a cup of coffee versus another person with $1. Both people have just enough money for one cup of coffee. But the person with $2 puts some in their pocket and leaves the rest for future spending, while the person with $1 spends it all on their single cup.
This difference between saving and spending applies to every aspect of your financial life:
– You can save or spend any extra income you make at the end of each week/month/year (after paying bills).
– You can save or spend retirement income when you get closer to retirement age (and after you retire if you’re self-employed).
– You can save or spend investment returns, whether that’s in the form of building up cash or increasing your investment accounts.
– You can save or spend social security benefits (and similar types of income).
This concept is simple, but it has huge implications for nearly every aspect of one’s financial life.
Compound Interest is an exponential growth effect on money due to reinvesting earnings – also known as making your money work harder for you.
Compound Interest is when the interest on deposits in a bank account, savings account, certificate of deposit (CD), etc., are added to the principal sum. As a result, the interest will earn more money based on the amount originally invested plus all previous gains. This allows even small sums to grow into large sums over a period of time.
Investing versus Borrowing
Investing is when you use your money to create a financial asset that will potentially generate income and appreciate in value over the long term, such as shares of stock or real estate.
On the other hand, borrowing is when someone gives you their money to spend on something with the expectation that they will get it back later, usually with interest. Usually, this means taking out a loan through a bank, but credit cards and even payday loans function as “short term” borrowing instruments for those carrying high debt loads.
Risk tolerance describes how much risk one can handle emotionally before being overwhelmed by fear or greed when investing.
An individual’s level of risk tolerance can be correlated with age, time to retirement, children, income levels, and amount of savings.
Boglehead experts suggest that the investment policy statement should guide market volatility during recessions, depressions, inflationary episodes, and deflationary episodes.