Understanding some basics about personal finance doesn’t guarantee that you’ll never make mistakes but it can save you a lot of grief. As an example of this, here are six financial concepts you should know that could keep you from making some serious financial blunders.
Understand the difference between wants and needs
There are things you need in life and things you want. It’s important to understand the difference. The needs are fairly limited – shelter, food, companionship and clothing. All else is just stuff we want and, unfortunately, our “wants” can be endless. Whenever you’re faced with a purchase decision, you need to ask yourself is this a want or a need. If it’s a want, you have a choice to make and will need to live with the consequences. This can be frightening but it can also be inspiring.
The fact is that some of your choices are made by scarcity. It could be your years left here on earth or the money in your wallet. In any event, there’s only so much of it. If you’re out of money before the end of the month, you may be ignoring this reality. People who continue untenable spending by using home equity loans, credit cards and other irresponsible borrowings to fund their lifestyles will have fewer choices available in the future. The money they waste on interest charges or other stuff is money that can’t be used to satisfy other goals such as retirement.
Know about ”Opportunity cost”
The meaning of “opportunity cost” it is where we forego something to get something else. For example, if you spend money going to college you’re giving up the money you might have earned working during those four years. But you’re forgoing this money for a greater good – a career that will earn you thousands of dollars more than if you had not gotten that degree. Almost all the choices you make have opportunity costs and determining those costs could help you make better financial decisions.
Discover why to get off the hedonistic treadmill
If you were to get a raise at work or buy a new big screen TV, this may make you happy for a while but then you soon start to take the situation for granted. Then your expectations rise: if I could only get a better car, a bigger house or another raise – things would be even better. You can satisfy those expectations, be momentarily satisfied, then adjust and want more. If this sounds familiar, maybe you need to get off this hedonistic treadmill and maybe look beyond your wallet for true happiness.
Stop throwing good money after bad
Many of the choices we make in life have what are called “sunk” costs. These are expenses we have already incurred and cannot be recovered. The “sunk cost fallacy” is a belief that that with some more money, time or effort we can resurrect the value that’s already disappeared. For example, you could invest in a stock that totally tanks. But you decide to continue to hold the shares rather than sell them and accept the loss. However, by holding on to those shares, you won’t have money to invest somewhere else at a profit.
Know about the time value of money
This gets down to a very simple concept – that the dollar you have today is worth more than a dollar that you’re promised in the future. There are several reasons for this. One is that the dollar you get today is is worth a dollar, while the dollar you might get in the future will probably not be worth a dollar – due to inflation. In addition, the dollar you get today can be invested to make you more money in the future.
Understand the role that risk plays
Almost every human endeavor includes some amount of risk. When you invest, you have a choice of investing in something safe such as a treasury bill that has a low rate of return versus large-company stocks that usually beat inflation. You may want to take some risk to be inflation but be careful of any company that “guarantees” a high return on your investment. It’s always wise to remember the old adage, if it sounds too good to be true it probably is.