Important Personal Finance Concepts

The management of personal finances for a family or an individual can be a difficult task without careful planning and consideration. Don’t worry, avoiding large debts and gaining the most out of the household’s weekly earnings can be done. Being familiar with a few finance concepts can help shape a beneficial understanding of how to optimize your personal finances. We at MoneyBuddy have identified four main concepts that can assist in managing personal finances.

1) Compounding

The definition of compound interest is: when interest is added to a principal amount so that the interest that is added earns interest itself. Essentially this means that the interest is charged based on the principal amount, which changes each month as interest gets added to it, assuming the interest is compounding monthly.

A good example that explains this concept is as follows.

Initial amount = $100

Interest rate = 5%

Month 1: Interest earned = 100 x .05 = $5

New principal amount = $105

Month 2: Interest earned = 105 x .05 = 5.25

Principal amount = $110.25

Month 3: Interest earned = 110.25 x .05 = 5.5125

Principal amount = $115.7625

2) Opportunity cost

One of the formal definitions of this concept is, the sacrifice related to the second best choice available to someone who has picked among several mutually exclusive choices. People do this everyday without realizing it. It is just the cost associated with choosing to do a certain thing, when you could be choosing to do something else. In a business sense, an example of opportunity cost could be found by looking at production. If a food company produces 1000 units of bread worth $1500 instead of making 1000 units of cheese worth $2000. The opportunity cost is the difference between what the company made producing bread and what the company would have earned if it had produced cheese. In this case it = $500.

3) Risk vs Return

This concept just refers to the age-old idea that, “the greater the risk, the greater the return”. The same also can be said in reverse however. The concept applies mainly in regards to where you put your money. Placing your money in an interest earning bank account with a low, stable rate of interest is low risk with a relatively low return. Whereas investing in stocks in the share market or other external investment opportunities carry with them more risk but the potential for a higher return. Other factors can influence this risk vs return idea as well, such as age, income and your natural attitude towards risk. If you are young, and just starting your career, you might be willing to take more risks with your money than someone who is nearing the retirement age.

4) Diversification

The final concept looks at reducing risk by investing in a variety of assets and is probably best explained by the phrase; “don’t put all your eggs in one basket”. This certainly applies in personal finance, particularly in the share market. Successful investment is about creating a balance between maximizing return and minimizing risk. This can be shaped around other external factors as well, such as, your aversion or attitudes towards risk in life in general and the level of income earned. Constantly checking the status of your stocks and money is also essential because as stocks rise in value you may want to diversify further or re-balance your portfolio to minimize the inherited risk associated with the rise in value.

Navigating through personal finances can be tricky for the most financially minded people. Establishing a basic level of understanding of some of the key concepts in finance can help the everyday money-smart person better manage their finances with the aim to maximize profit and minimize loss, lowering risk to individuals and their families or households.

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