There are a lot of different concepts and jargon when it comes to personal finance. I?m going to explore the concepts and areas that I think are the most important to me in my quest for financial independence.
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Personal finance is such a broad area that one could easily spend days trying to get on top of everything that is covered. Saving, investing, taxation are such involved and detailed area that you could break these down into hundreds of smaller topics. In my view however, there are probably just a handful of topics that you have to have a really good understanding of to make smart financial decisions.
Financial risk
This is a really important one, and I?d probably rank this top on the list. You?re ability to derive strong returns are directly correlated to how much financial risk you are willing to take. I define financial risk as the risk associated with the preservation of capital.
There is no such thing as a free lunch in my view, and the same holds true in chasing investment returns. Each of us has our own ?risk return trade off that we are happy with in pursuit of investment returns.
I for one, am happy to bypass government bonds. The tiny rates of return that are currently on offer from bonds globally, specifically government bonds, don?t make it worth the time to invest. Frankly, I am happy to take far more risk for the prospect of substantially higher returns, which is why I have made my path with a dividend investment strategy.
Of course, investing in individual stocks carries the prospect of a complete loss of capital, which you can mitigate to a degree with careful stock selection. ?Investing in a basket of stocks such as an ETF or a managed fund helps minimize that risk to a much larger extent.
There is a less well understood financial risk associated with investment in bonds in my view. While bonds are considered safe investments, their rate of return in a low interest rate environment may actually be such that bond returns don?t keep up with inflation. Thus while your principal may be safe, real returns from bonds may get eroded over many years by steadily increasing rates of inflation.
Taxation
Taxation is another area that not much attention is given to in my view, but an area that is exceptionally important. People are generally accustomed to thinking about their returns on a ?pre tax basis rather than in a post tax way.
However what you ultimately take home is far more important than what you may happen to earn on headline, notional terms. Certain forms of investment are far more tax effective than others. Regular interest, for example tends to attract taxation at an individuals marginal tax rate, whereas dividend income from dividend paying stocks tends to be capped at 15% for most people.
Regular wage income tends not to attract any special type of tax deduction. More to the point, its subject to a whole host of taxes that non wage investment income doesn?t attract, such as medicare and social security taxes as well as other state taxes.
This actually collectively makes investment income far more tax efficient than wage income. Its why the rich have very low rates of effective taxation, and why I think dividend income is far more tax effective than ordinary wage income.
The power of compounding
I?ve heard it said that Einstein referred to compounding as the 8th wonder of the world. If so, its with good reason. The ability for individuals to grow their investments at progressively faster rates as each dollar gets reinvested is truly pretty amazing.
It also helps explain why the best time to start investing is as soon as you reasonably can. Compounding investment dollars at an early age can leave you with a significant amount of wealth later on in life.
An investor in The Coca-Cola Company ?who invested $10,000 about 50 years ago would have had a stock value of almost $500,000 today. If you think that?s impressive, consider the scenario where those dividend were reinvested. That same investor would have almost $1.75M in an investment in The Coca-Cola company!. Talk about an acceleration in wealth from compounding returns!
Debt can be ?valuable tool
Many of us have been conditioned to the thinking that all debt is bad, whether its credit card debt, student debt or mortgage debt. We want to get rid of it, as soon as possible.?Whatever you have should be paid off in a hurry so that you dont have any of it. This is true in some ways, and not true in others.
We are all familiar with various types of nasty debt. This is the type of debt that you feel you are drowned by. The debt that you can?t seem to make any inroads into and that you keep trying to extend, transfer and roll over. ?And its almost always the debt that is used to buy personal good.
Its the type of debt that you wrack up on credit cards, personal loans. This type of debt is particularly bad because the value of the underlying assets that you are financing decreases over time. You basically incur interest charges against an asset that is going down in value!
However debt can be good. It can?help you acquire assets that increase in value over time. It can help you increase your return on equity as those assets increase in value and give you a tax break for paying interest.
Margin debt, for instance?can help you purchase more stock that what you otherwise could have, and thus grow your total asset value faster over the long term. Housing debt can get you a deduction for interest that you pay, as well as get you a high growth asset, not to mention a permanent roof over your head!.
My Takeaways
- Investment returns are directly correlated to the investment risk you are willing to take. Low investment returns can have financial risks that aren?t always apparent.
- Taxation is a powerful tool in helping you keep more of what you make, and it can help to have an awareness of the basics.
- Compounding interest really is the 8th wonder of the world!
- There?s something to be said for using other peoples money to build wealth- if one is comfortable with the risk involved.
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Source: http://www.financiallyintegrated.com/saving/financial-literacy-whats-important-to-know/
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