Finance for Beginners: Some Basic Concepts

Introduction

In a previous post, we emphasize the need for this series by understanding what finance is and how it relates to everyone, alone or as a group. Before we get into the more practical parts of finance, this post covers certain jargon and other concepts you will oftentimes encounter because of how integral they are to the act (and art) of financing.

Proper understanding of these fundamentals will set you on the path of making more informed decisions toward achieving financial stability. This guide breaks down essential terms and principles that the average finance beginner will be grateful to know.

Money

Money is a term for what we use to buy things, from needs like food or clothes, to wants like a sweet treat.

Cryptocurrency is basically digital money. Imagine the amount in your bank account or notes in your wallet existing mainly on the internet; more specifically, a part of the internet called the ‘blockchain’. However, you can still use this digital money to buy things online. The crypto blockchain is decentralized, so rather than any one bank controlling all the money, everyone who uses the digital money can keep track of who has how much. While it is a little technical and complicated, decentralization makes it fair and hard for any one person to cheat or control everything.

Funding

Funding is a situation where money is raised to buy something important which typically costs a lot. People often save or gather money together to start businesses or projects. Therefore, funding can be a solo or group act.

Income vs. Expenses

Income refers money earned from various sources such as salaries, investments, or business profits. Expenses, on the other hand, are costs incurred to live and maintain your lifestyle, including rent, groceries, utilities, and entertainment. Managing the balance between income and expenses is the foundation of financial health.

Budgeting

Budgeting involves creating a plan for how to will spend money you have or plan to receive. It helps you track income and expenses, ensuring that the party is operating within their means. Effective budgeting helps prevent overspending and help you save for future goals.

Saving vs. Investing

Saving is setting aside money for future use, typically in a low-risk account like a savings account. Investing involves putting your money into assets like stocks, bonds, or real estate with the goal of growing your wealth over time. While saving is generally safer, investing offers the potential for higher returns.

Inflation: Time Value of Money

Inflation reduces the purchasing power of money over time. The time value of money principle states that a dollar today is worth more than a dollar in the future because of its potential earning capacity. Understanding this concept is crucial for making informed investment decisions.

Liquidity

Liquidity refers to how quickly and easily an asset can be converted into cash without significantly affecting its value. High liquidity assets include cash and marketable securities, while real estate and collectibles are considered less liquid.

Bear vs. Bull Market

A bear market is characterized by declining asset prices and investor pessimism, while a bull market features rising asset prices and investor optimism. Understanding these market conditions can help you make better investment decisions.

Asset Allocation and Diversification

Asset allocation is the process of distributing your investments across various asset classes (stocks, bonds, real estate) to balance risk and reward. Diversification involves spreading investments within those asset classes to reduce exposure to any single risk. Both strategies are key to building a resilient investment portfolio.

Risk Tolerance: Risk/Reward

Risk tolerance is your ability and willingness to endure financial loss in your investment strategy. Higher risk often comes with the potential for higher rewards, while lower risk usually means more stable but lower returns. Knowing your risk tolerance helps you make investment choices that align with your financial goals and comfort level.

Simple vs. Compound Interest

Simple interest is calculated only on the principal amount of an investment or loan. Compound interest, on the other hand, is calculated on the principal amount and also on any accumulated interest. Compound interest can significantly increase your investment returns over time.

Capital Asset Pricing Model (CAPM)

CAPM is a model that describes the relationship between the expected return of an investment and its risk. It helps investors understand the potential return on an investment given its systematic risk, as represented by beta. CAPM is widely used for valuing stocks and assessing the cost of equity.

Depreciation

Depreciation is the gradual reduction in the value of an asset over its useful life. Businesses use depreciation to allocate the cost of tangible assets like machinery and vehicles over time, reflecting their decline in value.

Amortization

Amortization refers to the process of spreading out a loan or intangible asset's cost over a specific period. For loans, it involves making regular payments that cover both interest and principal, reducing the loan balance over time.

Credit

Credit is the ability to borrow money or access goods and services with the understanding that you will pay later. Managing credit effectively involves maintaining a good credit score, which impacts your ability to get loans, credit cards, and favorable interest rates.

Conclusion

Understanding these key financial concepts is essential for managing your personal finances effectively. Whether you're budgeting, saving, investing, or planning for the future, a solid grasp of these principles will help you make informed decisions and achieve your financial goals.