Are you new to personal finance or often feel like a newbie with some terms used in finance? Well, it is always recommended to learn about the basic concepts first to move ahead in any field.
So, in this blog, we will discuss some basic financial concepts you must know. You can share this with your buddies, who are newbies.
Estimated read time: 3 minutes and 50 seconds
Hint: Strong foundation makes you sound smarter.
Buckle up, here we go!
Do you like Polo Candy? I, for one, love it. A few years back, I could buy a pack that had 20 polo’s for ₹5. But now, I get only 10 polo’s for the same ₹5.
Do you see what happened here? Inflation happened. My ₹5 has lost its value. I cannot buy the same things as before. And therefore, people always recommend investing your money to grow it beyond inflation.
Currently, the inflation rate is around 7%. If your investments earn over 7%, you are becoming wealthy. If your investments earn less than the inflation rate, you lose money.
Did you hear that compounding is the 8th wonder of our world? Thanks to Einstein, everyone keeps reminding us about this wonder. But what is it?
Let’s say you have saved some money in the bank, and they give you interest on the amount. That is your money + interest = simple interest.
But with compound interest, the bank pays interest on the interest too.
For example, if the bank pays you a monthly interest of 1% on your savings. And you saved ₹1 lakh in the bank. The bank will pay you an interest of ₹1,000 for the first month. And in the second month, they will pay you 1% on ₹1,01,000, that is ₹1,010.
As the months go by, the interest you receive keeps increasing, thanks to compounding. Amazing right? Compounding is so remarkable that Einstein said that “He who understands it, earns it. He who doesn’t, pays it.”
Check out this story of a chessboard and rice grain to understand it more clearly.
A credit score is a three-digit score that measures your trustworthiness to pay back loans. It ranges from 300 to 900. A rating agency evaluates your credit history and allots a score.
Lenders usually consider a score above 750 as good. Having a good credit score helps in getting quick approval for loans and better interest rates. If you never had a credit history, you can start building your credit score with a credit card. Be sure to pay bills on time.
You would have heard about capital gain/loss a lot while filing income tax returns. Capital gain/loss is calculated for tax purposes.
When you sell an asset, the gain/loss is calculated by subtracting the selling price from the buying price. You end up paying tax if you traded with a gain or use the loss to adjust your taxable income.
For example, if you brought shares of a company for ₹1 lakh and sold them for ₹3 lakh after a few years, ₹2 lakhs is your share capital gain.
Yield is a return measure for an investment over a period, expressed as a percentage.
For example, if you own a property and rented it out. The rent collected is divided by your investment in the property. This gives you the yield. If the rent received per year is ₹3L and your investment (land value + construction) is ₹60L, then your yield is 5%.
Knowing the yield of your investments helps you in making better decisions.
Are you managing your investment portfolio with proper asset allocation based on your risk appetite and goals? Let’s say you followed an asset allocation of 50-50 between equity and debt.
What if suddenly your equity grows exponentially and your asset allocation changes to 60% equity and 40% debt? Your portfolio is riskier now compared to earlier. So you sell off some equity and invest it in debt to bring the asset allocation back to 50-50. This is rebalancing.
When you heard Elon Musk’s net worth breached the $300 Billion mark, what was your reaction? Did you ever wonder how it is calculated or how he can use it?
Well, am not sure about the usage part, but I can tell you how it is calculated. To calculate your net worth, you need to add all the assets you own, like – property, equity, cash, car, etc. and subtract the liabilities aka loans. If you own a property worth ₹50L and have ₹10L in cash, and you owe a bank ₹15 lakhs, your net worth is ₹45 lakhs.
Elon Musk’s net worth is calculated in the same way.
As we are talking about adding assets to calculate the net worth, let’s also discuss different assets because not every asset is helpful in the long term.
Appreciating & Depreciating Assets
Property, cash, gold, laptop, stocks, car, PF, etc. – What is common in them? They all are considered an asset.
But only some appreciate in value over time. I mean the value of stock, gold, PF, and property increases over time. The value of cars, cash, and laptops decreases over time and there comes a time when their value is zero.
So be wise while picking the assets to invest in. You need to invest more in appreciating assets and less in depreciating assets.
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