Credit/finance

6 Core Personal Finance Concepts

Lashonda March 19, 2024 0 Comments

This week, we will be looking at six core concepts of personal finance. We assume that everyone knows these concepts because we work in the field. You may also have a different understanding of these terms than the industry. Let’s go over these key concepts to make sure that we are all on the same page.

1. Savings Capacity

In the first meeting, we will want to know what their saving capacity is. Savings capacity is the key to wealth creation. Bricks are what you need to build a house.

Savings capacity is the difference in your monthly income after taxes and what you spend.

To determine our saving capacity, we must first be clear about our expenses. While some expenses, such as groceries, are fairly stable from month to month, other costs can vary depending on holidays, bills, gifts, etc., making it difficult to determine a reliable saving capacity.

Two ways can be used to solve this problem. Adopt a cash-flow strategy, such as the bucket method, to smooth the cost of bills and holidays. These strategies are detailed in my Financial Autonomy Book. Second, you should build some buffers. Don’t let your monthly living account go to zero. You may want to keep your account above a couple of thousand dollars, depending on the circumstances. When estimating your monthly expenses in your cash-flow plan, round them up whenever possible. Both of these methods give you a little cushion. Nobody wants to be confined by their finances.

It is more difficult to accurately estimate your savings capacity if your income fluctuates, such as if you are self-employed or work on commission. You should be able to predict your starting income confidently. Your savings capacity could then be $1,300 per month plus 60% of the quarterly bonus.

2. Emergency Fund

A personal emergency fund is a fundamental concept in finance. We are always thrown curveballs by life. You get laid off, your fridge breaks down, or you have to visit a sick relative abroad at short notice. Or, perhaps, your child is ill. These unexpected expenses are often what send people into a spiraling financial downward. They will need to borrow money, usually via credit cards, to cover these unforeseen expenses.

A fund for emergencies is money you have set aside that can be accessed quickly in case of an emergency. It isn’t set in stone how much money you should have in your emergency fund, but most people aim to save between three and six months of their after-tax income.

3. Compounding

Compounding is an important mathematical concept for achieving financial freedom and building wealth. If you invest $1,000 and earn 10% on it, you will have $1,100 after a year. This is the return you earned.

If you were to leave the earnings in your investment, and it again earned 10% in Year 2, then your $1100 would become $1210. In year 1, your earnings were 100 dollars, but in year 2, they were 110 dollars. In the second year, you earn more because you are earning a return on both your initial investment and what you earned in the first year. This process can be repeated in years 3, 4, 5, and so on, earning money from the previous year’s earnings. After eight years, your investment value will have doubled at a return of 10%. You have grown your $1,000 to $2,000 with little effort on your part other than to let it grow. Your $2,000 will become $4,000 in eight more years. Repeat this process, and you will reach $8,000.

Warren Buffett is one of the world’s most successful investors. He is one of the richest people on the planet because he began investing at a young age and survived until his 90s. It will take a long time for his investment to double and then double again. Compounding is a big deal.

Compounding is then earning a return from previous earnings. If you wish, you can earn interest on your previous interest.

4. Active Management vs Indexing

There are two ways to approach investment funds, such as those in your superannuation, managed fund, or exchange-traded fund. Active Management or Indexing.

Active Management was historically the dominant method. Active Management involves humans using their intellects to conduct research and decide which investments they should purchase based on the conclusions.

Indexing removes all of this thinking and replicates the market. An index of Australian shares would likely replicate the ASX200. If BHP is 11% of ASX200, an index fund for Australian shares will hold 11% in BHP. The index fund does not do any research and cannot determine whether BHP has a good future or is well managed. Index funds assume that the information has already been reflected in the share price due to the actions of active investors.

We all would like to believe that Active Management produces the best returns. Researching and thinking about what investments are good and which ones aren’t must produce a result. It’s important to remember that when you buy something, someone else will be selling it. Although you may have decided that company XYZ was a good buy, someone else has a different opinion. You can’t be both right.

Who is more correct? As an active investor, you don’t have to be right 100% of the time, but you must be at least 51%. Some active investors can certainly achieve this success rate. There must also be losers, and regular investors like me, who do more than stare at the stock exchange, are likely to end up on that side.

This is why countless studies show that index-type investments are the best way to invest your wealth.

This does not mean we should do nothing when it comes to investing. It is important to determine how much money to allocate to each asset class, such as shares or bonds. There is also research that shows active Management tends to be more valuable in certain sectors. This is especially true in the small-cap sector, where thorough research can yield greater rewards. Active investment is also a good option if you are looking to make your portfolio reflect an ethical concern. For example, you may want to invest in such a way as to impact the current energy transition positively.

It’s important to note that it is not as simple as indexing, which is good, and active Management, which is bad. Understanding the differences between the two concepts is a fundamental personal finance concept that’s worth understanding.

5. Gearing

Gearing. Borrowing and investing. Gearing is a common strategy for people who are successful in building wealth. In most cases, we will borrow money to purchase our home. Over the past decade, the property values of many homeowners have increased, which has led to a significant increase in equity. The opportunity to increase wealth and financial stability is provided by rising home equity.

Gearing can magnify an outcome. Gearing is not guaranteed to produce a positive outcome for you. It can magnify outcomes both in a positive and negative direction. It would be best if you had an asset that will grow in value with time to be successful. This overtime factor is crucial. The value of shares and property can change dramatically in one year, whether it is a share or a property. Over ten years, we can be confident in our growth.

It was easy to design a gearing system that would produce a positive return when borrowing rates were only two or three percent. The world is different today, as borrowing costs are now double what they were a few short years ago. More rate increases are likely. At this time, gearing strategies need to be carefully considered.

6. Accumulation Phase vs Pension Phase

My final core concept in personal finance is to understand the difference between the accumulation phase and the pension phase. Here, I’m talking about superannuation. When we begin working, superannuation is a mandatory account. The purpose of superannuation is to provide us with financial support when we retire.

You are in the accumulation phase if you are still working. This is when you are accumulating money in your superannuation, taking advantage of compounding, and building a nest egg.

You may not have thought about what happens to your superannuation when you retire. Superannuation’s Pension phase is the answer. Your Super fund now shifts to reverse. Instead of adding money to it constantly, it will start paying you out, usually monthly.

Superannuation’s accumulation and pension phases are distinct in a variety of ways beyond just the obvious cash flow differences. In the accumulation phase, you cannot access your savings. Technically, they are called “preserved”. You can only access them if you’re at least 60.

Once you enter the pension phase, everything changes. While the main purpose of the phase is to provide you with a regular income, your capital will be available once you enter this phase. Imagine, for example, that you reach retirement age due to a divorce and still owe money on your mortgage. You could withdraw a lump sum from your superannuation once you get the pension phase to pay off this debt.

The tax treatment is another important difference. In the accumulation phase, all income is subject to a 15% tax rate, and gains are 10%. Tax rates on income and capital gain are zero once you enter the pension phase. The government is considering changes to the rules. However, they will only affect people with large balances.

That’s all I have for you on my six core personal finance concepts.