Dubai: Successful planners – those who stuck with their initial plans – achieved an average total net worth three times higher than those who didn’t plan, research and surveys often indicate.
The essentials change when you have more in cash to manage. Once you’re in the six figures, those blips in interest rates and dividend yields quickly can add up to real money so you’re keenly interested in small changes. Although your cash stash is a hefty one, preservation and liquidity are still crucial.
However, understanding how to control your finances is a crucial life skill. If you understand the basics of good money management, you will be more prepared for the future and more financially secure.
There are a few foundational principles that can be used to study finance, which includes understanding the time value of money, knowing why higher the returns implies greater the risk and understanding how diversification of investments works to reduce overall risk, among others.
Relationship between money and time
A fundamental principle of finance is that money has a time value. In other words, a dirham earned today will be more valuable than a dirham earned in the future. Therefore, money can be invested in order to make more money.
This principle is concerned with the value of money, that value of money is decreased when time passes. The value of Dh1 of the present time is more than the value of Dh1 after some time or years.
So before investing or taking funds, we have to think about the inflation rate of the economy and the required rate of return must be more than the inflation rate so that return can compensate for the loss incurred by the inflation.
Inflation is the continual increase in the average price levels of goods and services. For example, Jim Smith buys a loaf of bread every week for Dh3.50, but if the price of the same bread increases by Dh0.30 due to inflation, it is possible Jim may no longer be able to afford the bread in the future.
Relationship between risk and reward
The next principle of finance explains the relationship between risk and reward. The higher the reward, the greater the risk.
The principle of risk and return indicates that investors have to conscious both risk and return, because higher the risk higher the rates of return and lower the risk, lower the rates of return.
To ensure optimum rates of return investors need to measure risk and return by both direct measurement and relative measurement.
This principle suggests that making a high-risk investment is a waste of resources if the return is small. For example, if Jim has the choice to invest in a bond that is not secured, the risk will be low for the secured bond (like a government bond) and high for the unsecured bond.
What is an unsecured bond?
An unsecured bond, or commonly referred to as a junk bond is a bond that is not rated highly, which means that there is a high chance that there will be a default on the investment.
If Jim invests in the junk bond, he may not be paid. On the other hand, the government guarantees that the holder of a government bond will get their money back.
Secured bonds are also considered low risk because they are backed by an asset, such as a car or house, that a lender can claim ownership of should the borrower default on the loan. This is important, since it reduces the risk of the investor losing their gains.
The relationship between risk and reward demonstrates that low risk offers low return while higher risk offers the potential for higher return.
Diversification of investments and minimising of risk
The next principle of finance states that diversification of investments, or distributing investments and risk over many different businesses, can reduce the investor’s overall risk. This is important because lack of investment diversity can increase the investor’s market risk.
This principle helps to minimise the risk by building an optimum portfolio. The idea of a portfolio is, never put all your eggs in the same basket because if it falls then all of your eggs will break, so put eggs by separating in a different basket so that your risk can be minimised. To ensure this principle investors have to invest in risk-free investment and some risky investment so that ultimately risk can be lower.
For example, if Jim only invests in oil stocks and there is a shortage of oil in the marketplace, all of his holdings will be affected. However, if Jim diversifies his portfolio to include grocery stores and music recording companies, he can expect more stability because his risk is distributed across the marketplace and not concentrated in one type of business.
Do you know how markets affect your money?
Another principle of finance states that financial markets are efficient in pricing any asset or security. The market follows news on a company, future forecasts, supply and demand, and other factors.
Depending on historical information, this principle may not be the best strategy for investors, since financial markets are efficient in themselves and the financial environment is always changing.
Another key market principle of finance is that a money manager’s and shareholders’ objectives may differ. The manager is doing what they believe is best for the business.
On the other hand, the shareholder wants the value of the stock to go up so that he or she can sell the stock at a higher price to maximise their wealth.
Role of business cash flow, profitability and liquidity
The cash flow principle mainly discusses the cash inflow and outflow, more cash inflow in the earlier period is preferable than later cash flow by the investors. This principle also follows the time value principle that’s why it prefers earlier more benefits rather than later years benefits.
The principle of profitability and liquidity is very important from the investor’s perspective because the investor has to ensure both profitability and liquidity of anything he or she invests.
Liquidity indicates the marketability of the investment i.e. how much easy to get cash by selling the investment. On the other hand, investors have to invest in a way that can ensure the maximization of profit with a moderate or lower level of risk.
What role does business reputation play w.r.t your investments?
Reputation has a significant influence on an investor’s decision whether or not to invest in a financial instrument. A financial instrument is a legal document representing the right to receive an asset such as cash, a contractual right to deliver or receive cash, or another form of owned equity that can be traded.
Companies with good reputations will inspire more people to buy their stocks. Companies with bad reputations may have difficulty convincing people to buy stocks. For example, investors would rather buy shares in Microsoft than Enron.
(Enron was a US-based energy company that perpetrated one of the biggest accounting frauds in history.)
In the past, Enron’s lack of ethical behaviour called its reputation into question. Ethical behaviour is behaviour that is consistent with what society, businesses, and individuals typically think are good values.
Investors are wary of companies such as Enron, which manipulated its financial statements to make its position appear better than it was. This kind of unethical behaviour costs investors a large amount of money in a short period.
Consequently, Enron went out of business when its fraudulent activities were discovered.
Workings of hedging and loans on your investments
Hedging principle indicates us that we have to take a loan from appropriate sources. For short-term fund requirement we have to finance from short-term sources and for long-term fun requirement we have to manage fund from long-term sources. For fixed-assets, financing is to be done from long-term sources.
What are fixed assets?
Fixed assets, also known as long-lived assets, tangible assets or property, plant and equipment, is a term used in accounting for assets and property that cannot easily be converted into cash. Fixed assets are different than current assets, such as cash or bank accounts, because the latter are liquid assets.
Finally, if you have a basic understanding of finance and its principles then you will be able to take financial decisions effectively – and there is a higher possibility to become gain bigger and reap bigger returns.