Five Finance Concepts A Savvy Investor Needs To Know

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Not every investor is as savvy as they could be. Financial education is not taught in high school. In fact, it’s only taught to college students who proactively seek out to learn about this topic. A lack of knowledge can hurt your portfolio so read on for 5 key finance concepts you must know as a savvy investor.

Inflation

Understanding the effects of inflation on your portfolio is paramount. According to Investopedia, inflation is a sustained increase in the general level of prices for goods and services. As inflation rises, every dollar you own buys a smaller percentage of a good or service. In other words, it chips away at the value of future cash flows. For example, if you invest in a 20 year bond that pays $10K per year, the payment at the end of the first year will buy significantly more goods and services than at the end of the 20th year.

Compound Interest

Compound interest is the interest calculated on the initial principal you invest but also on the accumulated interest of previous periods of investments you’ve made. The Rule of 72 is another way to look at this. Take your rate of return, let’s say 10%, and divide by 72 – your investment would double in 7.2 years. Take 1% and divide by 72 – your investment would double in 72 years. 

Buy-And-Hold Vs Timing The Market

The financial media often suggest that being an active investor and trying to time the market is your best option. However, every study on investing ever conducted shows the following. A buy-and-hold strategy, investing into a plain vanilla index fund, will outperform every hedge fund and active manager when paired with dollar cost averaging (making a set investment every month instead of trying to ‘time the market’). 

Diversification

Stocks in any sector or asset class fluctuate in value over time with the ebbs and flows of the economy. Some companies are cyclical, which also contributes to market fluctuations. This is entirely normal. Investing in a single stock can be wildly profitable, like Amazon, or a disaster, like Enron. Unfortunately, there are a lot more Enron’s than Amazon’s, just as there are a lot more strike outs than home runs in baseball. By broadly diversifying, you remove the risk of any one loss wiping out a substantial gain (or all) of your portfolio.

Risk Vs. Reward

Modern Portfolio Theory indicates that the higher the return on your investments, the higher your risk is that your money won’t be there when you need it. For example, hedge funds are considered high return/ high risk investments and treasury bonds are considered low return/ low risk. This is why you would want to balance lower returning, less risky assets, with higher returning, risking assets.