Financial Concepts

We have made a list of the basic financial concepts needed to prosper financially. You must understand all of these if you are to really understand your own personal finances and learn how to drastically increase the likelihood of building long term, sustainable wealth.

List of some important Financial Concepts

1.   Time Value of Money

Time value of money is the change over time, in the value of money, when either earning interest or due to inflation over a period of time. Time value of money is the vital component when looking at your personal finances over time.

For example, R10 000 of today’s money invested for one year and earning 6% interest will be worth R10 600 after one year. Therefore, R10 000 paid now or R10 600 paid exactly one year from now both have the same value to the recipient who assumes 6% interest; using time value of money terminology, R10 000 invested for one year at 6% interest also has a future value (FV) of R10 600.

Inflation has the same effect, if we assume an inflation rate of 5.8%, and a current (present, PV) value of R 10 000, in 5 years time an amount with equal (future, FV) value or buying power would be R 13 256.48.

The method also allows the valuation of a future stream of income, in such a way that the annual incomes are discounted and then added together, thus providing a lump-sum “present value” of the entire income stream (Cash Flow).

Time value of money describes how important the value of time is in building wealth. Money invested today is worth more than money invested at any point in the future due to the fact that it has more time to grow or compound. It is also the main reason that you’ll want to get started with your investing as early as possible. R1 today would be worth 0.50c in less than 12 years, assuming a 6% inflation rate.

The most basic law in finance! The time value of money states that a rand today is worth more than a rand in the future.

Let’s look at the reverse of this, to see how the time value of money can work against you. Suppose instead of receiving R1,000, that you spent R1,000 by some consumable on your credit card. Remember that a rand today is worth more than a rand tomorrow, so in this case, you will have lost money because you will need to pay off your credit card account with money from the future (which is worth less than money today). In addition to having to pay with future money, you will also have to pay an expense called interest. So, in this case, if you paid off the credit card in one year (assuming 15% interest), you’d have to pay R1,150, for a purchase of R 1000 today. Future value of R 1 150 = Present value of R 1 216.70 (Inflation of 5.8%). You basically paid R 1 223.40 for something that should have cost you R 1000!!!

Think about time value of money before making any financial decision. Another, significant concept related to the time value of money is the compounding effect of money/interest.

2. Compounding Interest

Compound interest arises when interest is added to the principal, so that, from that moment on, the interest that has been added also earns interest. This addition of interest to the principal is called compounding. A bank account, for example, may have its interest compounded every year: in this case, an account with R1000 initial principal and 10% interest per year would have a balance of R1100 at the end of the first year, R1210 at the end of the second year, R6 727 after 20 years.

The only way of comparing one interest rate with another is to compare the frequency rate. Since most people prefer to think of rates as a yearly percentage, many governments require financial institutions to disclose the equivalent yearly compounded interest rate on deposits or loans. For instance, the yearly rate for a loan with 1% interest per month is approximately 12.68% per annum. This equivalent yearly rate may be referred to as the effective interest rate. These government requirements assist consumers to compare the actual costs of borrowing more easily, but still we lack the discipline of actual doing this!!!

Compound interest may be contrasted with simple interest, where interest is not added to the principal (there is no compounding). Compound interest is standard in finance and economics, and simple interest is used less frequently

The compounding effect of money/interest is extremely important when making any financial decision. The compounding effect of money is often overlooked or underestimated by people when making money decisions, and the effect of small changes on time or cost/fees are not comprehended. When applied to all of your financial decisions, this effect is the KEY to long-term success! To illustrate the compounding effect of money, let’s use some financial examples:

Suppose you had invested R1 000/pm in an investment account, with an annual yield of 10%. After 20 years, your investment will be worth R 759 369. R 519 369 interest,         R 240 000 capital savings. After 30 years, your investment will be worth R 2 260 488,   R 1,9mil interest and only R 360 000 savings. That’s the effect of compounding interest!

To accumulate wealth, you MUST use the time value of money and the compounding effect to your advantage.

This second example shows how the compounding effect can work against you:

Suppose you borrowed R100 000 to purchase a car and your car loan was at an 11% interest rate (for 5 years). Your monthly payments would be R2 174.24. Because the R100 000 loan continues to compound over the life of the loan, you actually pay R130 455 over the five-year period, meaning that you’ve in essence paid R30 455 interest because you spent the money before you had it. In fact, in your initial payments, the interest alone will account for almost 63% of your monthly payments. In this case, the bank or lender that gave you the loan uses the time value of money to their advantage.

Now look at this scenario, where instead of making the R2 174.24 car payment, you invest that payment at the same rate as what your car loan was. Now, instead of paying the bank, you are actually earning interest and compounding the benefit for yourself. After one year you will have saved R27 447 and have earned R1 356 in interest. After two years, you will have saved R58 071 and have earned R5 889 in interest. By the third year, your investments will be worth almost R93 000 and you will have earned R13 965 in interest. By month 39, you will have enough money to purchase a R100 000 car in cash!

So let’s weigh the differences between the two scenarios above. In the first case you paid the bank R30 455 to borrow the money and in the second case you earned R16 585 and could buy the car in cash after just 39 months (just over 3 years)! The car might cost a little more due to inflation but you will still be much better off. The opportunity cost of the first alternative versus the second alternative results in a net difference of R47 040 (a R16 585 plus versus a R30 455 negative). That means that by making a simple deferral decision (buying the car in 3 years versus today), you can get ahead by almost R47k, 47% of the R 100 000!!!

3. Budgeting

Budgeting is the most important way to understand and take control of your finances. Creating a budget can be a daunting task and it requires that you fully commit to tracking your expenses, creating your spreadsheet, analysing the results, and then making improvements on an individual basis. Here are some important tips:

  • Track your monthly spending and try to account for every cent spent. For the next month or two, think very closely about how your money is spent. Every time you buy something, pay a bill, or dispose of any of your cash, make a strong mental note of what it is being spent on. Better yet, at the end of each day write down a list of all your expenditure and what it was used for on a piece of paper or a spreadsheet. Try to think critically about each cent spent and whether or not it was a required expense. Keep a spreadsheet with all of your expenditures for a month before you create your budget. While you are collecting the expense information, try to label each expense with the following attributes:
  • Assign each tracked expense to a category. For example, buying groceries would go under your grocery expenses. Use very specific categories instead of broad category descriptions. For example, if you are buying groceries for a party, the expense category wouldn’t be food, or even groceries, but would better fit under entertainment. Instead of food expenses, be more specific and include categories for dining out, take out, food gifts, snacks, coffee breaks, impulse food buys and even holiday food purchases. When it comes time to analyse your budget, you can easily add up all these expenses to compute your total food costs.
  • In addition to assigning each expense to a category, determine if each expense is discretionary or non-discretionary. Back to the food examples, a discretionary expense would be buying coffee, while a non-discretionary expense would be buying the groceries that feed your family. Discretionary expenses are items on your household budget that you do not require to live. They may not be expenses that you are willing to give up, but they are expenses such as entertainment, dining out, DSTV, non-essential clothing purchases, gifts, and any other expense that isn’t required for you to live. Non-discretionary expenses, on the other hand, include items like your bond payment, taxes, insurance and basic utilities, food and clothing costs. Non-discretionary expenses are required for you to survive, but that doesn’t mean that they can’t be reduced. You’ll want to mark each budget item as discretionary or not so that when it comes time to analyze your household budget you’ll already have this step completed.
  • It’s time to create your household budget spreadsheet. To do this, you need to quantify and categorize all of the spending patterns you observed in the previous step. If you were already able to assign categories and tag each expense as discretionary or non-discretionary, then this step should be easy.

Now that you’ve created your household budget, look for areas to improve. Define the goal of your budget: Is it to save money? To understand where you are spending your money? To pay debt? To find a way of saving more? Regardless of your goal, there are always ways to improve your budget. Here are some tips on how to focus on changing and improving your budget:

  • There are really only two ways to improve your budget, either increase your income or decrease your expenses. Since income is normally fairly fixed, focus on reducing your expenses by finding ways to save money would be the first priority.
  • Start with your most expensive debt and settle that first. Go to debt management.
  • Control your spending.
  • If possible, find ways to make more money. Raising your income is more difficult than cutting your expenses because you have less control over your income.
  • One of our tips is to rent your primary residence and buy a second property that you can let at a later stage. First settle other debt.

4. The Key to Saving

Did you know that if you saved R1 per day and invested it at 10%, you’d have almost R195 524 in 40 years? Every little bit counts and it is very important that you take this financial advice, get out of debt and save money – and start saving it now! There are thousands of ways to save money.

You can save money in many different ways. For example, buying groceries that’s on sale, store or buying things on sale that you’d buy regardless of whether or not it was on sale, save you money. You can also save money by foregoing spending until a future date or by foregoing spending on non-essential items. Self-control can be a real issue and if the money isn’t allocated to a specific item, the tendency is to spend it on impulse and luxury items that are non-essential. If you find yourself in this category, or have trouble saving, you should create an investment account that is automatically debited from your account each month. To do this, you may need to create a monthly household budget to determine your monthly savings goal. If you do create a budget, make sure that it is realistic, matches your lifestyle and that it leaves plenty of room for miscellaneous expenses that seem to pop up regularly. If you create an unrealistic budget you’ll likely save less than what your budget calls for, become frustrated, and resort to your old ways. You can save through, Endowment policies, Retirement Annuities, Unit Trust investments, stock markets, buying property, commodities etc

The next rule is to invest with a new frame of mind.

Diversify your Risks and Investments. Another important concept to keep your finances balanced. Don’t keep all of your money in just a few assets like your property or bank account. Make sure that you spread your investments over many different asset classes, equity, bonds, cash, property etc. The Compounding Effect of interest on Money should never be forgotten. Understanding this is key to being able to forecast future growth. Your money may grow at the same rate each year in terms of percent, but in terms of actual rand growth, compounding means that your money will grow faster and faster each year as a result of earning money not just on your investment, but also on the returns from that investment. (Snowball effect)

Remember if you postpone starting your investment, it is not the first year or three that you lose, but the last year or three!

Be aware of fees charged!!!

a) If you want to build real wealth you need to take some risks. The higher level of risk that you take, the higher your return/volatility would be. With that said, only take the risks that are appropriate to you, complete a Risk Profile Questionnaire!

b) For example: You have the choice of investing in a savings account, a money market account, cash deposit, bonds, a blue chip stock and an aggressive unit trust fund (mostly offshore stocks). Each investment has a different level of risk and each investment makes sense for different people, typically, the higher level of risk that you take, the higher your potential investment return. The right investment for you depends on many things, age, % of total available cash/capital, planned investment time, risk aversion, type of investment and purpose of investment are just some, but the three most important factors are:

  • fees/cost.
  • realistic time horizon,
  • aversion to risk, and

Regarding fees/cost, did you know that saving 1% on cost per annum can increase your capital by up to 26% over 30 years?

Regarding time horizon, if you have 40 years before retirement, you should invest your money in the highest risk, highest yielding sectors (maybe 75-100% equities (max 75% allowed according to regulation 28 funds, retirement money), 15% bonds and 6% property and 4% cash). But if you are already well into retirement or can’t afford to risk your investments, the majority of your investments should be allocated toward the lower-risk investments such as bonds, money market accounts and cash. This depends on your total financial portfolio as you must remember that equities and property are still the asset classes producing higher returns.

Regarding risk aversion, you must make this decision yourself. If you have trouble sleeping at night because you’re investing in stocks, you should probably sway toward the lower risk investments. Different investors have different tolerance for risk/volatility. Risk takers tend to be more aggressive than they should and risk adverse investors are usually too conservative. Try to stay somewhere in between the two to find a safe portfolio that can still offer inflation+, beating returns. (Complete the Risk Profile Tool)

With the correct asset class allocations you can probably have a fairly low risk investment with a return above inflation. It is important to take risks, the more risk you take the more you can expect to earn or accumulate over term. However, be conscious of yourself and your goals and do not take more risk than your time horizon or your own personality will allow.

5. Inflation

In economics, inflation is a rise in the general level of prices of goods and services in an economy over a period of time. When the general price level rises, each unit of currency buys fewer goods and services. Consequently, inflation also reflects erosion in the purchasing power of money – a loss of real value in the internal medium of exchange and unit of account in the economy. A main measure of price inflation is the inflation rate, the annualized percentage change in a general price index (normally the Consumer Price Index) over time. If your investments do not outperform inflation you are becoming poorer, losing purchasing power.

Inflation’s effects on an economy are various and can be simultaneously positive and negative. Negative effects of inflation include a decrease in the real value of money and other monetary items over time, uncertainty over future inflation which may discourage investment and savings. Positive effects include ensuring central banks can adjust nominal interest rates and encourage investment in non-monetary capital project.