Use Basic Financial Concepts to Build Wealth

People often say that it takes money to make money, and this is true to some extent.  The truth about building wealth lies in the snowballing effect produced by a few basic financial concepts.  To truly build wealth, you must take advantage of these basic financial concepts regardless of your financial worth.  Most of you are probably aware of some of the benefits of these concepts, but may not really know why they are the key to building wealth.  Here are some guidelines about what the concepts are and how to use them to your advantage.

Understand the Basic Financial Concept of Compounding

There is no bigger concept to understand than how compounding rates of return can help you build wealth.  Compounding happens when your investments grow each month, and you earn the rate of return on your initial investment, and on the growth from your initial investment.  For example, if you invest $100,000 and earn 5%, you will earn $5,000 after the first year.  Next year, however, you will earn interest not on just the $100,000, but on the full $105,000.  That means that in the second year, your return will rise from $5,000 to $5,250.  From year to year this concept is barely noticeable, but over the years, as your investment continues to grow, you will soon be earning more each year than you initially invested.  That’s because the compounding effect continues to accelerate the growth in your investments.

Use Time Value as Another Important Financial Concept

This basic financial concept is based on the time.  The time value of money works with the compounding effect to really build wealth quickly.  The time value concept basically means that a dollar invested today is worth more than a dollar invested at some point in the future.  For example, if you invest $10,000 for retirement at the age of 20, it is worth more than investing $10,000 for retirement at age 30.  That is because the money invested earlier will have more time to grow and compound than money invested later.  This concept explains exactly why it is so important to start investing as soon as possible.  The longer you wait, the more this basic financial principle will work against you.

Look at All of Your Opportunities

Building wealth means looking at all of your opportunities before you make any spending decision.  This basic fiancial concept is called opportunity cost. For example, if you invest $100,000 in a certificate of deposit at 2% interest for one year, the opportunity cost would be that you couldn’t invest that money in anything else.  Alternatively, you could invest that same money in a corporate bond and earn 7% or invest it in the stock market and earn as much as 20%. When making any financial decision, you must look at all of the alternative decisions that you could make, in order to make the decision that will maximize your long term wealth.  For example, here’s the opportunity cost of buying a new car for $40,000 versus investing that money in the stock market at 10%.  After 5 years the car would be worth about $15,000 and the stock market investment would be worth $64,420.  The difference, or opportunity cost, is a whopping $49,420, or more than you would have spent on the car.  Look at all of your spending decisions with opportunity cost in mind.

Understand the Concept of Diversification

Diversification is another basic financial concept.  Most people know the laymen’s term “don’t put all of your eggs in one basket”, which is the most widley used quote describing this concept.  However, most investors don’t really pay attention to this concept when actually investing.  The concept means that you should diversify your investments and assets across many different asset classes so that your investments and assets are protected from large declines in any one stock, industry or asset class.  For example, if you use all of your money to buy a house, you are not diversified.  Your assets will rise and fall with the cost of real estate.  If you have all of your investment money invested through your employers stock plan, you are not diversified. In fact, not only do you stand to lose all of your money, but if that happened, you would also probably lose your job too.  As your portfolio expands, more diversification is needed.  As you diversify more, consider investing in domestic, foreign, growth, emerging, dividend, technology, manufacturing stocks; as well as in real estate or real estate funds, and bonds, commodities and maybe even a small business.  And check your mutual fund holdings to make sure they don’t overlap. Many investors own several mutual funds that all own the same few stocks.

Accelerate Your Wealth Building With Higher Rates

The last basic financial principle that can help you build wealth is your rate of return.  Rate of return can really mean interest rate, investment rate, stock market return, and even debt cost (a negative return).  Obviously, higher rates of return will make your portfolio grow quicker.  However, most investors aren’t aware of just how much difference a few percent can make.  Higher rates work hand in hand with the time value and the compounding effect mentioned above to truly accelerate your wealth.  For example, if you invested $100,000 for 30 years at 5% it would be worth $432,000.  However, at 7%, that same investment would be worth $761,000.  As you can see, just two percentage points makes a 75% difference in the wealth you create.  It is for this reason that it’s important to keep your investment fees low.  Don’t hire a financial advisor unless you need one, and buy low cost mutual funds or ETFs when they fit your portfolio.  Low cost funds are often a full percent lower than other funds, and an advisor often charges a full percent or more to manage your money.  Just making these two changes could double your wealth over your lifetime.

Now that you’ve got an understanding of how these basic financial concepts work and how you can apply them to your lives, please feel free to leave us a comment with how you’ve been able to apply them specifically to your life.

Investing basic financial concepts