Basic Concepts in Finance
This article concerns finance, that is, the study of how resources are valued, allocated and invested over time. Having knowledge of the basic concepts of finance is important not only for business owners, corporate executives and financial planners; ultimately, financial planning is each individual's responsibility. Three of the most fundamental concepts in finance are the time value of money, asset valuation, that is, how the value of stocks, bonds, real estate, and other investments is determined, and finally, risk management. While the time value of money is the basis for the other concepts, financial planning and investing ultimately require an understanding of risk management. This article will approach the basic concepts of finance for the individual and provide an overview of financial and investment products.
Keywords Asset; Asset Valuation; Bond; Certificate of Deposit; Compound Interest; Debt; Defined Benefit Pension Plan; Defined Contribution Plan; Financial Planning; Government Securities; Individual Retirement Account; Interest; Investment; Money Market; Money Market Deposit Account; Money Market Fund; Mutual Fund; Real Estate; Risk Management; Sarbanes-Oxley Act; Savings; Stock; Time Value; Treasury Bill
Finance: Basic Concepts in Finance
It is becoming increasingly important for individuals to assume responsibility for planning a financial future. Successful financial planning, in turn, requires one to understand the basic concepts of finance since this understanding will afford one the ability to save and invest wisely. This means that the individual needs to have knowledge of a variety of financial products and investments and comprehend how these vehicles work. Moreover, for many people, the largest investment they will make is purchasing a home. Having knowledge of the basic concepts of finance will enable them to understand mortgages and consumer debt in general. Saving, other investments and managing debt are all based upon the foundation of the first financial concept — the time value of money. Further, this concept is a building block to asset valuation and risk management. Asset valuation requires one to understand how the value of assets such as stocks, bonds and real estate are determined. Finally, understanding such concepts as compound interest and inflation can empower an individual to manage the risk of their investments over time.
However, recent research indicates that many people are financially illiterate — they do not have an understanding of the basic concepts of finance. People cannot differentiate between individual stocks and stock mutual funds, nor do they comprehend that investing in individual stocks is riskier than investing in mutual funds. Further, there is a general lack of knowledge about compound interest and inflation. This lack of knowledge reflects the fact that many people do not understand how money works, and this in turn is manifested in the way people invest or fail to invest their money. For many, their primary investment vehicle is their company provided defined benefit plan or a defined contribution plan. A defined benefit plan is commonly referred to as a fully funded pension. However, pension plans are becoming less common as employers are shifting this benefit to a defined contribution plan such as a 401(k). Unfortunately, many people are not aware of the differences between these two types of plans and some are not certain which type of plan their employer provides. The result of this lack of knowledge is that the overall savings rate declined dramatically during the late twentieth and early twenty-first centuries (Carlson, 2005), and only started to rise in the wake of the 2007 recession (Samavati, Adilov, & Dilts, 2013).
More importantly, the amount of consumer debt dramatically increased as the twentieth century came to a close. This is reflected by the fact that more people carried higher amounts of unsecured consumer debt such as credit cards. This trend, as is the case with the overall savings rate, has slightly reversed since the 2007 recession (Brown, Haughwout, Donghoon, & van der Klaauw, 2013). In addition to an expansion of unsecured debt, the rise in home ownership over the last 20 years combined with the rising value of real property has resulted in a surge of mortgage debt. In order for the individual to be able to adequately finance this debt requires an understanding of the basic concepts of finance.
While having an understanding of the basic concepts of finance is important to understanding the value of savings and investing, saving is really a matter of common sense money management. In this regard, there are four ways to simply start saving.
- First, large amounts of cash should not be kept on hand, but rather deposited into a savings account.
- Second, although paying outstanding bills on time is important, there is no benefit derived from paying bills early and this money can continue to earn interest.
- Further, some people intentionally have more taxes withheld in order to obtain a refund. However, that excess money could also be put to better use by earning interest.
- Finally, once the amount of money a person is saving begins to accumulate, it can then be invested in other ways to earn even more interest such as by opening an interest bearing checking account (Miller, 2003).
Instruments for Saving
Certificates of Deposit
Another vehicle available for savings investment is a Certificate of Deposit or a CD. Investing in a CD is essentially a time-deposit savings device that requires an investor to keep the money in the account for a specified period of time. That period can be for as little as 3-6 months or as long as 5 years. In return for this, the interest rate paid by the bank is higher than the interest rates based on savings accounts or interest bearing checking accounts. The longer the term of the CD, the higher the interest rate that will be paid. In addition, there is usually a penalty for withdrawing the money early.
Money-Market Deposit Account
Another type of savings account available for basic investing is a Money-Market Deposit Account (MMDA). This is basically a means of saving that is a cross between a savings account and a Certificate of Deposit. An MMDA requires an investor to maintain a minimum balance ($1,000) while allowing for a maximum number of three checks to be drawn each month (but automated deposit machine withdrawals are not limited).
Money Market Mutual Fund
In addition to the MMDA, an individual can also invest in a Money Market Mutual Fund. Opening this type of fund requires a minimum initial deposit, usually $1,000, $5,000 or more depending on the financial institution. The institution uses the money invested in these funds to borrow and lend money on a short-term basis. This includes such investment vehicles as commercial paper (short-term debt obligations issued by a corporation), Treasury bills (short term debt issued by the Federal government), federal government securities such as "Ginnie Maes" (GNMAs) and "Fannie Maes (FNMAs) as well as others short term debt instruments (Miller, 2003).
Benefits of Savings Instruments
The main benefit of the foregoing savings instruments is that they allow an investor to earn interest on their money without a great deal of risk. The general rule of thumb regarding saving money is that one should have six months of living expenses set aside. This is not money to spend or to be used for making large purchases and should only be used in case of an emergency or loss of income. Having this money set aside will also enable an individual to minimize their debts. As mentioned earlier, not saving enough money is one of the biggest financial mistakes that people make. Another way to save money is to open an Individual Retirement Account (IRA) or contribute to an employer sponsored plan such as a 401(k). Investing in these instruments enables an individual to invest in stocks, bonds, mutual funds, certificates of deposit, money-market funds, and the like (Chatzky, 2004).
In addition to understanding financial concepts that are at the root of all these investments, it is also helpful to comprehend the goal of investing, and the benefits of investing in stocks, bonds, mutual funds, and even real estate. An investment is basically the use of money for the purpose of creating more money. This can be accomplished by putting money in income-producing vehicles, such as the various savings vehicles that earn interest mentioned above. Interest is essentially the cost of using money, usually over a one-year period and an interest rate is the rate charged for using that money. For example, if a bank was offering an interest rate of 2% per year on a basic savings account, and an initial deposit of $1,000 is made, after one year, that account would have $1,020 On the other hand, interest rates are charged on bonds, credit cards, and other types of consumer and business loans. If a bank charges $600 per year on a loan of $100,000, the interest rate would be 6% per year (Downes, 2006).
Interest rates on consumer loans are important to understand if a person is buying a home. Financing an investment in real estate usually requires obtaining a mortgage from a financial institution. A mortgage is a debt instrument a lender uses to place a lien on real property purchased by the borrower. A lien is a creditor's claim, in this case the lender, against property (Downes, 2006). By understanding the time value of money, a person will be better able to understand how much a mortgage will actually cost over 30 years. By understanding asset valuation, a person can determine the value of the house, or the...
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