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How is it possible that over a million people file for bankruptcy protection each and every year?
In a country where the average family makes a decent wage, where food is cheap and plentiful, and where housing in many places at current interest rates is dirt cheap, it must take a real effort to end up with less than nothing. If I were to pick a single word of to explain the high bankruptcy rate it would be ‘Finance’. If this was a war, on one side you would have a bunch of financial geniuses armed with an arsenal of products and on the other side, you would have a group of unsophisticated borrowers failing to understand or simply not caring to understand that they signed up for war duty. As Warren Buffet said: “If this were class warfare – my class is winning.”
Now don’t get me wrong, there are many sophisticated borrowers, and for them, there isn’t any war going on. They’re as neutral as the Swiss. All they want is reasonable borrowing at good rates in exchange for a reasonable amount of profit.
For the unsophisticated borrowers, it’s a lopsided battle and it shouldn’t be. Personal finance should be a required course at every high school in America and if it were, you would see a substantial decrease in bankruptcies. Until that time comes, you need to study up on it on your own.
Time Value of Money:
Perhaps the one concept that underlies all of finance is that money tomorrow is worth less than money today. Its the fundamental concept that is behind both investing and borrowing. If I gave you 5 dollars this year and you gave me back 5 next year in return, there isn't much incentive for me to do it, unless you happen to be my son. Now if I give you $5 today and you give me $6 in a year, we might have a transaction. That's a pretty good deal. Or is it? It might be an awful deal for me if I was in Zimbabwe where the value of their local currency is halfed roughly ever day and a half (Inflation). Or perhaps if you had a history of skipping town whenever you owed me money (Risk), it might not be a good deal.
Return:
A financial return is the ratio of what you earned from your investment compared to your investment. In our case above, its a 20% return. If the return spans multiple years, you might see an annual return which is the return when compounded over the period of the investment. Take our 20% return again, if it took you 3 years, it would be a 6.2% return. What is really important about returns is to understand what the norms are over long periods of time. The stock market, housing, bonds, money markets, etc all have long term averages. By understanding these, you will know when something is historically out of alignment and due for a correction. For instance, if the stock market has returned 25% per year for the last 5 years, its isn't sustainable since the long term average is about 10%. Conversely, if you have 29.99% interest on your credit card, it will be obvious to you how hard it is for you to get out from under this ultra high rate. Study the financial returns and profit from it.
Compounding:
The core concept that you need to grasp is that compounding interest works for you as an investor and against you when you borrow. Compound interest and simple interest are very different over long periods of time. To learn more about compounding, read Compounding: Your Best Friend or Worst Enemy.
Leverage:
Another important concept in finance is leverage. A few years ago, everyone was touting the superior benefits of leverage in getting wealthy fast. Unfortunately, leverage works both ways as millions of people have found out. Leverage essentially boils down to the ability to multiply your return by investing only a fraction of equity and load up with a lot of debt. For instance, buy a house with 20% down and for every 1% increase in the price of a house, you will see a return of 5% on your investment. Using leverage carefully can create massive wealth from a small investment, but it can wipe you out. That same house if it went up 20% would create a 100% return on your investment, but if it fell by 20% you would lose everything. When to use leverage is extremely important. A great rule for a conservative investor is only use leverage where the cashflow from the investment pays for the borrowing costs of the leverage.
Taxes:
Once you get the basics of compounding down, you should understand how taxes affect everything that you do. Earn $30 an hour and after taxes you might take home $21. So if you are buying something that costs $30, it actually takes nearly an hour and a half of work or $43 to pay for that item. With sales taxes, it's more like $47 or 1.6 hours. Factor in sales taxes because they make your expenditures on most items that much more expensive. It's one of the chief reasons that people have turned to the Internet not only to lower costs, but to avoid sales taxes.
If you don't want to take the time to understand finance then do yourself a favor, eliminate every monthly payment that you have. Buy everything up front, whether its an annual gym membership, your car, or even your house. Leave only those things that you only have a monthly option like your utilities. When you have enough money hire a reputable financial manager and you won't have to learn anything about finance. I'm guessing that most of you aren't going to be able to pull this off so it's back to learning about finance again. Finance is somewhat intimidating until you understand the core concepts. If you have an average math background and access to a spreadsheet, you can learn a ton in just a few days.
If you want to get a good book on it, the Dummies series has a pretty good one:
Personal Finance For Dummies that can be had for about $15.
Some Key Articles for Finance:
Loans: Understanding Amortization
5 Cheap Maxims for Investing in the Stock Market
Learn to Hate Your Debt
The Only Good Debt in Town
Read these articles or buy a book and you'll understand a bit more about debt, compounding, and investment. Trust me, the more you know about finance, the smarter your decisions will be in the future.
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