People always think personal finance is rocket science. They get confused over the different terms used by Financial Planners in their blogs, TV interviews or direct interaction. But in reality, it is not a big deal. One can learn these concepts easily. If we understand these concepts well we can take well-informed financial decisions for our bright future.
Let’s have a look at the widely used terms in Personal Finance
You must have heard the term “Power of Compounding “. This concept is based on the mathematical term Compound Interest. In simple words, compound interest is interest on interest.
E.q. 10,000 Rs are invested in a fixed deposit of a bank for 2 yrs at 8% compound interest. Then in the first year principle is 10000 and interest earned is 800 Rs. For the 2nd year, the principal amount is 10800 and interest earned is 864 rs. Thus, at the end of the 2nd year, the total amount received by an investor is more than interest which is earned, not taken out rather invested again. When an investor is being invested in the financial product for the long term, the power of compounding helps to build the wealth.
This is one of the important concepts which an investor should understand while planning his/her finances. Many times’ investor forgets to take into account Inflation while calculating the corpus required for the specific goal. Because of this mistake, his corpus is left short off for the particular goal.
What is inflation.?
A sustained increase in the general level of prices for goods and services is called Inflation.
Have you noticed the number of grocery items which you were able to buy in 1000 Rs last year has been reduced in this year? Why so? The reason is that prices of grocery items increased and the purchasing power of 1000 Rs decreased in one year. This inflation reduces the purchasing power of the currency over the years if kept idle in the form of cash or in bank saving account as this money can not earn any return. So the investor should invest his saving in those financial products which have the ability to generate returns over and above the prevailing interest rate.
This term depicts the financial position of the investor.
How can we calculate the Net worth ?
Net worth = The total Assets – total liabilities of the individual.
Liabilities include debts and different kinds of loans taken by the individual and assets include cash, mutual funds, stocks, bonds, real estate, and gold etc. High net worth indicates a sound financial situation of the individual.
This term is widely used by the financial expert. It plays an important role in maximizing the portfolio return.
What is Asset Allocation ?
Asset allocation is the process of deciding how to divide your investment across several asset categories. Stocks, bonds, Mutual funds, other debt instruments and cash or cash alternatives are the most common components of an asset allocation strategy. Asset allocation means diversifying your portfolio.
In simple words invest your money in different types of an investment product to minimize your risk and maximize the returns. The asset class can be equity, debt, real estate and gold. Asset Allocation depends upon your age, risk-taking ability and time horizon for the particular goal.
The most famous phrase ‘Never put all your eggs in one basket’ is used to simplify the term Asset allocation.
Re balancing is a process of buying and selling the investment over a period to maintain your asset allocation. This is done by reinvesting the profits that are taken out of some outperforming investments and putting them in underperforming assets. Re balancing brings your portfolio back to the desired asset mix.
You should make necessary changes in your Asset allocation mix with changes in your age, income, time frame of considered for the goals and nearing of the life goals by re balancing the portfolio.
Re balancing is also done for the short term in view of market fluctuations.
Net income/ Disposable income
Disposable income is that income which we have available to spend or save.
How to calculate disposable income ?
This is derived from total income- taxes to be paid.
This is cash in hand. Disposable income also has economic significance. Not only is it one of the major determinants of consumer spending, but it is also one of the five determinants of demand.
Thumb rule regarding disposable income is that we should save at least 30% of our disposable income, and spend 20% on luxuries and rest 50% on necessities according to 50/30/20 rule.
Debt is a sum of money that is owed or due. We need to borrow money when we cannot buy things from the money we have. In personal finance, debt is of two types.
Good debt and Bad debt.
Good debt is that loan which we have taken to build up our assets which are appreciating in future such as home loan, a loan taken for commercial property or land etc. This loan helps us to create assets in the long run.
Whereas bad debt is that debt where we borrowed the money to own the depreciating assets such as Car loan, personal loans for electronics or travel. These loans increased repayment burden and reduce the available amount for saving.
Thumb rule is that all types of debt should not be more than 30% of our disposable income.
These are some important terms which an investor should know.
Understanding of these terms helps the investor to plan his/her finances well.