Personal finance is full of concepts that can intimidate newcomers. In reality, being smart with money doesn’t require being a mathlete or getting an MBA.
Many complex-sounding financial principles are actually quite simple, and understanding how they apply to your finances can pay huge dividends.
Here are six financial concepts explained in a straightforward way.
1. Compound interest
For savers, compound interest is like fuel to a flame. The mathematical magic happens when your principal balance earns interest — which then becomes part of your principal, allowing it to earn interest itself, and the cycle repeats. (Experiment with this compound interest calculator to see the magic in action.)
Why it matters: Putting money aside — even relatively small amounts — is never a futile exercise. For example, a single $1,000 investment earning 6% compounded annually will become roughly $4,300 in 25 years. Commit to adding an extra $100 a month in savings and, thanks to compound interest, the balance will swell to more than $70,000.
On the flip side, beware of the consequences when you’re paying interest instead of collecting it. The snowball effect can be financially devastating when it applies to an unpaid credit card balance growing ever larger as interest adds to your balance month after month.
2. Opportunity cost
Choosing where to spend your money involves making trade-offs. Opportunity cost is the value of the choice you did not make compared with the option you did chose. For example, the opportunity cost of your morning Danish is the $2 you could have spent on anything else.
Why it matters: Measuring the bottom-line opportunity cost can help you make better financial decisions. For example, which is the better investment: leaving money in a bank account earning 1% or less annually in interest, or using the funds to pay off a credit card balance with a 14% interest rate?
Sometimes the true cost of the opportunity not taken is apparent only over time, such as choosing the “safe” investment of cash versus investing money in the stock market. Over the short term, you avoid the sometimes harrowing ups and downs of the market. But over the long term, cash diminishes in value because of inflation. And you lose out on the proven long-term returns of a diversified stock portfolio.
3. Dollar-cost averaging
Dollar-cost averaging is shorthand for investing set amounts of money at regular intervals, such as once per week or month. Having money diverted from each paycheck into a 401(k) plan is an example of dollar-cost averaging.
Dollar-cost averaging is a smart strategy … especially during periods of market volatility.
Why it matters: Dollar-cost averaging is a smart strategy in all market conditions, but especially during periods of market volatility. Since the set amount of money buys more shares when the stock price goes down and fewer shares when it rises, it evens out the average price you pay, ensuring you don’t buy in bulk at high prices.
There’s also the psychological benefit: Automatically deploying funds on a regular basis takes the emotion out of investing and helps investors resist the urge to try to guess which way the market will move.
4. Risk versus reward
Risk refers to the possibility that an investment will perform poorly or even cost you your initial investment. Generally speaking, a low-risk investment will deliver lower potential returns. The more risk you’re willing to take on, the more potential upside there is — and the higher the likelihood that you could lose your shirt.
Why it matters: If you know you absolutely need the $100 in your pocket to pay for something next month, you want to stick the money in a conservative investment (cash or certificates of deposit) where the principal is guaranteed to be there when you need it.
In broader terms, money you need in the next five years (for a down payment on a home, as income while in retirement, for an anniversary cruise) should not be invested in the stock market. Consider certificates of deposit or money market funds instead.
Don’t need the dough for a while? You can afford to weather the short-term market blips and take on more risk. Learn more about the trade-offs between short-term and long-term investing goals.
The act of spreading your eggs across different baskets is how investors build a portfolio that doesn’t turn into a scrambled, worthless mess on the way to the end goal. Generally, the baskets here are asset classes: stocks, bonds, mutual funds and cash. Drilling down even further, you can diversify among those classes, especially with stocks, by varying things like company size, industry and geographic location.
Why it matters: Diversification is a way to reduce your exposure to risk. When one investment zigs, it’s likely other investments in the portfolio will act differently (zagging) to smooth out returns.
As long as we’re on the topic of diversification, we’ll sneak in two related terms you’re likely to run across: asset allocation, which is the balance of assets within a portfolio, and rebalancing, which is the process of adjusting a portfolio that over time has strayed from its ideal mix.
6. Active vs. passive investing
There are two main approaches to investing. The active strategy, like it sounds, involves hands-on money management, investing in and getting out of stocks based on the results of research and the market’s fluctuations. Passive investing is the buy-and-hold approach, where investors purchase shares in companies they believe will deliver a positive return over the long term and hold onto the shares regardless of short-term price fluctuations.
If you own mutual funds, you’re exposed to either active or passive management.
Why it matters: Even if you don’t invest in individual stocks, if you own mutual funds (within a workplace retirement plan or an IRA), you’re exposed to either active or passive management. An actively managed mutual fund is headed by a person who chooses the investments in the fund. Index mutual funds are considered passive because the investment mix simply mirrors a particular section of the stock market.
Because passive funds aren’t managed by a high-priced professional money manager, investors pay much lower management fees to own them, meaning more of their dollars get invested instead of eaten up by fees. That’s why even investment manager extraordinaire Warren Buffett encourages regular investors to buy low-cost S&P 500 index funds — which you can do on your own with relatively little investing experience.