Six financial concepts you’ll actually use

On February 17, 2017 in Financial Management

Six financial concepts you’ll actually use

By Melissa Sotudeh, CFP

Learn more about Melissa on NerdWallet’s Ask an Advisor

Financial jargon often sounds horribly dry, but I get excited about it because the concepts it represents can have such a big impact on everyday life. These aren’t just terms to be learned for a test or that wealth advisors use only at work. These ideas can help you save money, gain financial security and find opportunity.

Here are definitions of a few key phrases and concepts to know, and an explanation of why each is important.

Cost per use/Cost per unit

A measure of the utility of a purchase, found by dividing the item’s cost by the number of units it contains or the number of times you’ll use it

Take a moment to do this calculation before you buy, and you’ll make better shopping choices. For example, if you tend to spend about $150 on a new winter coat every year, it would be less expensive to buy a $250 coat that is designed to last for three years or more.

It’s generally a good idea to shop with a low cost per use in mind, but there is one caveat: Just because something costs less in bulk doesn’t always mean it’s a better deal. Consider how many “uses” you’ll get out of a purchase before it goes bad (or it gets outgrown, or otherwise becomes unusable).

Diversification

Holding different types of investments — including domestic and foreign stocks, bonds and other asset classes, such as real estate — to reduce your risk in case one type underperforms

Just like your grandma said, don’t put all your eggs in one basket. This is just as true for other aspects of your life as it is for your portfolio. For example, you might diversify retirement income sources with tax-deferred and after-tax accounts or diversify the food you eat for proper nutrition.

Liquid reserves

Cash or cash-equivalent assets that can be accessed quickly without affecting the value

It’s important to hold a portion of your wealth in liquid cash reserves — typically in a savings account or cash-equivalent investments, such as Treasury bills — in case of an emergency or opportunity. If you received a high medical bill, for example, and the majority of your net worth was tied up in the value of your home, you’d need to take out a home equity loan or a reverse mortgage, or maybe even refinance, to get the needed cash. And you might need the money before you could complete any of those processes.

Liquidity can also be important in other ways. An example of this would be a job that gives you transferable skills. Even if your company failed or you lost your job, you would have an “asset” that you could use in a new career. The idea is to have wiggle room in many areas of your life in case of the unexpected.

Opportunity cost

What you lose when you pursue one opportunity and give up another

Choosing one path necessarily means not choosing another path. In a financial sense, this applies to picking one investment style over another. By leaving your savings in cash, you lose out on gains occurring in equities or bonds.

Opportunity cost has a clear application to career choices as well: Do you stay in a job that is currently stable, but in a dying industry? Do you decide to become a stay-at-home parent and put your career on pause? There are no easy answers to these questions, and sometimes the cost vs. benefit isn’t financial at all. It could have more to do with your relationships and values. However, it’s always important to understand what you gain and what you give up by making different choices.

Return on investment

A performance measure for investments, found by dividing the net gain of an investment by the cost of the investment

Return on investment is relevant to your portfolio, of course, but you can also use the concept to decide whether the time or money you spend on other parts of your life are worthwhile. For example, should you to spend an hour doing a particular task at work, or is the cost lower — and ROI higher — for your company if you delegate it?

Sometimes the answer is cut-and-dried, and sometimes it’s completely subjective. Is it better to buy a professionally made birthday cake or make one yourself? For some, the enjoyment of baking outweighs the enjoyment of giving a Cake Boss-worthy store-bought cake — and for others, it’s the reverse.

ROI applies to educational decisions, too. Not all colleges or majors provide an equal value for the investment. A bachelor’s degree from the Massachusetts Institute of Technology costs more than $200,000, but the school has a 90% graduation rate and its graduates have good job prospects. This gives it a better ROI than less expensive schools with lower graduation rates and whose graduates are less likely to find good-paying jobs.

Other parts of college life don’t have an exact dollar value, such as opportunities the school provides to network and study abroad. When you consider the ROI of major decisions like these, account for tangible and intangible factors in the gain/cost equation.

Compounding

Exponential growth that occurs as interest you earn on savings earns its own interest, typically over a long time period

Compounding can work for you and against you in the financial world. When it comes to savings and investment growth, compounding is a good thing. As your balance grows, the amount of interest you earn grows exponentially. But if you carry a balance on a high-interest credit card, debt can compound quickly. Albert Einstein is often said to have called compound interest “the eighth wonder of the world,” ostensibly noting, “He who understands it, earns it. He who doesn’t, pays it.”

Small actions in other parts of your life can have a compounding effect. Physical fitness is probably the closest equivalent, since even spending 20 minutes per day walking, taking the stairs rather than the elevator, or choosing a lettuce wrap over a tortilla wrap can lead to positive outcomes. The same goes for cleaning your house. You could do a major cleaning once per month or tidy up a bit every day to achieve a clean home.

Small positive habits don’t always have much of an effect on their own, but adopting many or repeating them adds up, just as gradually increasing your savings adds up to a healthy nest egg and retirement.

Melissa Sotudeh, CFP, is a wealth advisor at Halpern Financial, an independent, fee-only registered investment advisory firm in the Washington, D.C. region. She is also the author of the free e-book Find Your Financial Safety School.

The article 6 Financial Concepts You’ll Actually Use originally appeared on NerdWallet.

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