The Basic Financial Concepts

by on August 14, 2011

In our opinion, there are three basic financial concepts that are the most important financial concepts to apply to your investing and saving methodology.  Understanding these concepts and applying them to your savings and investments can greatly increase your long-term investment returns.  Understanding them will also help you understand why it is important to maximize savings, start early, and maximize your returns.  We’ll cover them one at a time using brief illustrations:

First, the time value of money.  The time value of money simply stated, means that a dollar today is worth more than a dollar tomorrow, and therefore, the sooner and longer you invest, the more money you will have in the future (at retirement).  Basically, you want to give your money as much time to grow as possible to maximize your investment portfolio.  So starting to invest and save at the age of 25 has a much higher success rate of meeting retirement goals than starting to invest at 45.  Below is an illustration of how the time value of money works.  We’ll simplifly the assumptions by assuming you start saving $500 a month at an annual rate of return of 6%.  Now let’s look at the amount of money you’ll have saved by the time you’re 65 assuming you start at different ages:

time value of money

As you can see from the chart, the basic financial concept called the time value of money illustrates that the longer you invest, the more massive your savings will reach.  Translating that to an actionable item means that you should invest as much money as you can as soon as possible, investments made today are worth dozens of times today’s worth years from now.

Second, the compounding effect of money.  The compounding effect of money concept, simply stated, means that money invested grows faster over time.  For example, if you invest $100 today at 10%, you will have $10 in one year.  However, the next year, your $100 will be worth $110 (the $100 plus the $10 return) and it will grow by $11 ($110 x 10%).  The third year, you will have $121 ($110 + $11 return) and will earn $12.10.  As you can see, each year that you have money invested, it will grow by a larger dollar amount.  This is the compounding effect of money and is one of the three most important basic financial concepts.  To illustrate the compounding effect of money over different interest rates, lets look at the illustration below.  The table shows the value of $500 per month invested over 30 years at rates of return varying between 1 and 13%.

compounding effect of money

To see how much the value of compounding has on your investment, look at the amounts you’ll have saved given different compounding rates.  Your savings would be around $2 million, or 10 times higher if you earned 13% instead of 1%.  So how do you apply this basic financial concept to your everyday investment philosophy?  Easy, try to make as high of a return as possible (without taking on too much risk).  That is why it’s important to invest in stocks and not to be too conservative with your investments.  As of today, CDs yield less than 1% and the stock market is averaging about 10% over the long run (not as much over the past 10 years though).  Anyway, you can see the difference interest rates and compounding make on your portfolio.

Third, the opportunity costs of money.  The opportunity cost of money is found by looking at alternative uses of your money.  For example, you could buy a new car for $30,000 or you could invest that money.  In five years your car would be worth about $10,000 and your investment would be worth about $38,000 (assuming 5% rate of return).  Therefore, the opportunity cost of buying a new car versus investing is $28,000!

This basic financial concept can be applied to almost anything in your life and it is very important to start thinking in terms of opportunity cost if you want to really start getting ahead financially.  Every purchase decision you make should be weighed against what else you could spend your money on.  In many cases, the right decision is to spend instead of save, but I would guess that many people would make better financial decisions if they really understood this concept.

Using all of these concepts together can give you the motivation you need to really start saving and investing.  Imagine if you made all the right purchase and saving decisions, did it while you were young, and then compounded those savings over the years.  That’s how people get rich and retire early!  And that’s how you should start thinking too!

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