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The Ten Most Important Finance Fundamentals for Everyone
By Matthew Lockwood
Smashwords Edition
Copyright 2012 Matthew Lockwood
Smashwords Edition, License Notes
This ebook is licensed for your personal enjoyment only. This ebook may not be re-sold or given away to other people. If you would like to share this book with another person, please purchase an additional copy for each recipient. If you’re reading this book and did not purchase it, or it was not purchased for your use only, then please return to Smashwords.com and purchase your own copy. Thank you for respecting the hard work of this author.
First Published January 2012
Cover image ‘la vida’ David Frahm 2011 used with permission.
Illustrations copyright Matthew Lockwood 2012.
ISBN 978-0-9872618-0-9
“It’s taken years to refine this content into
ten simple points. You will pick it all up in an hour or two”.
Matt
Lockwood, Author
DISCLAIMERS: This book is not financial advice. This book is written with the aim of providing financial education. Materials have been prepared with the intention to illustrate broad concepts only. It is not appropriate to apply the content of this book to individual circumstances. All reader circumstances are different. Readers are strongly advised to consult with appropriately qualified professional financial advisers before acting on any material in this book.
Neither the author nor any other party to the publishing of, or contributing towards the content of, this book may be held responsible for any action or claim resulting from the use of the book or any information contained in it. Information in this book is written at a single point in time, therefore is subject to change and content may become obsolete. While the materials in this book have been created with all due care, the author or publishers do not warrant or represent that the information is free from errors or omission, or that it is exhaustive.
TRADEMARKS AND OTHER ACKNOWLEDGEMENTS
Microsoft Excel is a registered trademark of Microsoft Corporation.
The University of South Australia’s Applied Finance program, delivered by the School of Commerce, has provided much of the theoretical framework central to my own knowledge base. I would particularly like to acknowledge the staff who deliver this and similar programs, as providing a critical service of financial education to the local and increasingly global community.
This book is a creation of my passion, personal effort and broad personal experiences. I have made all efforts to acknowledge specific sources that I believe may have influenced my thinking on a particular topic. These are listed as endnotes, where I also list other relevant sources of information the reader may wish to pursue independently.
Thanks to Nick Carne for editing along with John Barrett and Peter Lennox for their personal time taken to review this work and make technical suggestions.
Contents
1.The two most powerful words in the financial world; and how to create immense wealth.
3.Things you can invest in – without the smoke and mirrors.
5.Analysing returns and forecasts. What the ‘FFF’ actually matters?
6.Lies, damn lies and statistics.
8.Tax (Predominantly Australian content).
10.The king of the financial world.
Introduction
Today, more than ever, it is critical for you to be able to understand money.
If you don’t know much about finance, this book gives you important fundamentals – quickly. If you do know something about finance, this book will refresh and challenge your current knowledge.
The book is written in a different way to other books about money. Detail is not included.
Why? It’s the fundamentals that matter the most.
After a few years in business, many successful people when asked what they got out of their university education will say “the basics” or “the fundamentals”.
Often the detail is forgotten as real world lessons are combined with theoretical knowledge to produce more specialised skill sets.
But you do need that knowledge base.
These ten points started as a list of what I considered were the ten most useful personal finance concepts from my own original tertiary knowledge base – the Applied Finance degree at South Australia’s largest university, UniSA.
I then applied, refined and simplified this list based on my years of experience working in financial services, my own investing, further training, and being paid to teach others about financial concepts. The end result is what you are about to read.
You might not have the luxury of the time, money or circumstances to invest in years studying then working with money as I have. Then again, why spend years studying, when you have access to this ready-made knowledge base?
It’s taken years to refine this content into ten simple points. You can pick it all up in an hour or two!
1. THE TWO MOST POWERFUL WORDS IN THE FINANCIAL WORLD
If this heading was “compound interest” would you read on? If you are like most people that I talk to about this topic, you would nod your head and quickly turn the page.
STOP. Why then, did Albert Einstein say that compound interest is “the greatest mathematical discovery of all time" (1)
STOP. Read the last sentence again. Please.
Think about it. Think about who Einstein was. Before you say “oh yeah, I know what this is – it’s just earning interest on your interest” please ask yourself whether you deeply understand compound interest the same way that Einstein did.
Long-term compound interest investment strategies can make you wealthy.
This first fundamental of finance gives you a deeper understanding as to why.
How to create immense wealth for less than $10 a day
There are many catchy titles like this out there (2). Often the essence of what they are talking about is utilising the magic of compound interest over time for wealth creation – which is a great story and the reason why this is the first fundamental in this book.
Here’s a hypothetical example:
Today
A couple decides today that they want to give their newborn child, Chloe, ¼ of a million dollars when she is 30.
From that day on they both save $4.25 per day; e.g. each parent foregoes a cup of coffee or less than a case of beer each week and place $8.50 a day into a long-term savings facility.
In the future
Chloe is now 30 and the savings account has earned on average 6% per annum. The balance is therefore around ¼ of a million dollars (3). Not bad!
The regular savings then stop. No more $8.50 per day from mum and dad.
Suppose that the now 30-year-old Chloe lives in a world where social security, old age pension, superannuation (4) and public healthcare no longer exist. So Chloe needs to keep the money in the bank to fund her planned early retirement at age 55.
No extra money is added ever again.
The wealth materialises
At 55, and assuming the same rate of return of 6% per annum is achieved and no withdrawals are made, the money will have accrued to around $1 million.
Not bad considering if the $8.50 a day for 30 years went into a shoe box under the bed there would be $96,243 (5) – over $900,000 less!
So where’s the catch? There’s a few. You may have picked one already. For example $1 million in the future will not buy you what it will today. Investment earnings change over time, as do investment options. And there is the matter of tax. These points are all discussed later in this book.
Also discussed later in this book is the point that long term residential home loan interest is often described as the magic of compound interest “in reverse”. The bank wins, but the bank doesn’t always have to win, or not by such big margins anyway. That comes later also.
For now forget all the detail. Focus only on the mathematical marvel that is compound interest. Focus on the fascination that Einstein found in all this.
Following is my version of the best and most practical mathematics lesson that I ever received. And if you understand it and apply the principles therein great wealth can be yours – if you want it. Please read on.
How compound interest works
Following are three steps to a better understanding of exactly why long-term compound interest investing works.
Step one (of three): the must-know basics.
Know that there are two types of interest – simple interest and compound interest.
If you invest $1000, simple interest is simply calculated by multiplying the $1000 by the interest rate and then the period of time.
For example $1,000 at 10% per annum for one year will earn $100 in interest. Simple!
Compound interest is calculated in a different way. This formula raises the amount and the interest rate earned “to the power” of the time variable. You don’t just multiply like the above example. You raise the whole amount exponentially: “to the power of” time.
This is a wow factor. Here’s why:
Think about high school mathematics for just thirty seconds: If you multiply 2 by 50 you get 100. This is simple multiplication.
If two is raised to the power of two (i.e. 2 multiplied by 2) you get four. If two is raised to the power of three (i.e. 2 multiplied by 2 multiplied by 2) you get 8. If you raise 2 to “the power of” 50 (i.e. 2 multiplied by two and repeated 50 times) you get a much larger answer: 1,125,899,907,000,000 in fact!
Now you can start to feel “the power”!
Step two (of three): the importance of time
If you look at the following formula for compound interest you can see that the variable that is raised slightly higher than the other words in the formula is the time variable. Raising this variable is akin to multiplying again and again and again and again. Remember simple interest only multiples by the time once. Compound interest earns interest on top of interest on top of interest on top of interest again over time!
Relax – you don’t need to do any calculations! Remember this is just a deeper illustration of why long-term compound interest strategies are so amazing, which many people don’t truly understand.
This formula is shown because it is the reason why the longer the money is invested, the more money you make. This relationship is “exponential”, which means the earnings get larger the longer you leave it.
If you graph the relationship between time and returns for long-term compound interest investing, the curve actually looks like a half-pipe skateboard ramp.
That’s because your financial returns in a long-term compound interest investment strategy start off pretty flat when the account balance is low. A steep incline in the account balance will eventually start to occur as the “interest earning interest on top of interest” effect starts kicking in!
Your personal wealth will accumulate slowly at first (assuming you don’t have millions to begin with), but with patience things eventually take off and your earnings increase at an increasing rate!
Step three (of three): “the other stuff” about compound interest wealth creation strategies
Time is not the only variable in the compound interest equation. Here are a few more key points that you (or your financial adviser) will find valuable if you like the idea of creating wealth through long-term compound interest investment strategies.
Be disciplined and stick to your plan
* Patience is critical. As explained above, the compounding effect is much greater in later years than early years. Resist the temptation to withdraw money early, as this reduces your principal balance.
* Remember that returns in the early years of a long-term savings plan will seem to start off slowly. Be patient. The longer the money is invested, the greater the compounding effect (i.e. the interest earned on your savings) will be.
Start out with as much as you can
* The more you put in at the start the more you get out. Investing money earlier is much better than investing money later, because it increases the power of the time variable.
* The good news is that for longer-term investments, e.g. 10 years plus, the initial deposit is technically not as critical as the time, interest rate earned or regular payment variables.
Make regular deposits
* Making regular payments into the investment makes a big difference to the final amount. Making regular deposits can be just as important as the size of the deposits.
Earn constant, positive returns
*The higher the returns, the greater the compounding effect. Steady, consistently positive returns will work better than irrational returns with frequent losses.
Be prepared for the real world
*Remember that it is not high-cost, fancy financial products with secret bells, whistles and online graphics that make compound interest work. It’s the simple underlying formula, and especially…time!
Whatever you do choose your investment vehicle wisely. Don’t pay high product fees or sales commissions for returns you can obtain yourself for free by wise investing. If someone offers you returns that sound too good to be true, they probably are. That single sentence, although a cliché, is a fundamental of finance by itself.
2. THE TIME VALUE OF MONEY
If I borrow $1,000 from you and repay the full $1,000 a year later have you lost any money?
The answer is yes, because there is an opportunity cost to giving me the money.
Had you not lent it to me you could have put it into a savings account to earn interest, or reduced your credit card debt, or any number of things. If the interest rate on savings were 5% you would have earned $50 over the year.
Use this concept to save money on your next tax bill
If you get a large tax bill and had 6 months to pay it, with no extra charge financially speaking, why would you pay it early?
Financially that’s 6 months of interest that can be earned by you, not the tax office, if you were to pay the bill shortly before it is due, rather than 6 months in advance.
Just don’t be so clever to delay paying it but then forget all together and cop a late payment fine!
In case your friend ever owes you 1 million dollars
Similarly, pretend your friend owes you one million dollars, and says they can give it to you now, or next week when you catch up again. Take it now.
Never forget that money has a time value. It might sound simple and obvious, but the concept that money has a time value is the heart of the financial world (6).
3. THINGS YOU CAN INVEST IN
Knowing what’s behind the smoke and mirrors
There are thousands of people out there ready to tell you about how they can invest your money.
What I am about to say might sound elementary, but having a simple effective and up-to-date understanding of the four basic investment classes of cash, fixed interest, property and shares becomes critical when assessing all manner of financial products.
This is because of the millions of different ways you could invest your own or someone else’s money, most can be summarised, or ultimately derived from, any of the following four categories.
Many people lose money because they do not completely understand the underlying nature of what they are investing in, and therefore don’t truly comprehend the risks involved (7).
Following is a quick list of four major types of investments that you might contemplate placing your money into.
3.1 CASH
Cash in the bank is the simplest way to invest. You make money from interest paid to you from the bank, and your money is readily accessible. Your biggest risk should only be inflation. Inflation is the erosion of your money’s purchasing power over time due to rising living costs. Oh, and perhaps forgetting your pin number.
3.2 FIXED INTEREST
A “fixed interest” security or product is just another name for an IOU note. Examples include Government bonds, blue chip corporate bonds, finance-company debentures and term deposits.
You give the lender (the bank, the “issuer”) money and they promise to repay you at a date in the future, along with some regular interest along the way. The value of the IOU note can change for different reasons: e.g. if the issuer gets into trouble, or if interest rates change. If you want to you can sell the IOU note to someone else, although if the issuer is in financial trouble other people may not want to buy your IOU.
3.3 PROPERTY
You can buy property yourself directly. You can also invest in property through countless managed investment structures and schemes.