7 financial concepts everyone needs to understand
I’ve been in the financial services world a long time. My wife says too long.
Over that time, I’ve come to recognize that many of the people who come to me for help lack an understanding of some basic concepts that are necessary to make smart financial decisions. So I drew up a list of seven financial concepts that I believe everyinvestor, every 401(k)/403(b) participant and every high school graduate — I know I’m stretching, but I’m hopeful — should understand. In no particular order:
1. Cash on cash return
This is the cash return on an investment as a percentage of the cash you’ve actually put into that investment. It’s usually expressed on an annual basis, such as 10% a year. Comparing this figure among investments helps you evaluate performance and make decisions.
2. Effective tax rate
This is how much you pay in combined state and federal income taxes in a year. Start with the total tax calculated on your federal return, then divide it by the adjusted gross income on your federal return. Do the same with your state return (if your state has an income tax). Each calculation will produce a decimal result that you can convert to a percentage — 0.15, for example, would be 15%. Add the state and federal percentages together to come up with your effective tax rate.
3. Debt snowballing
This is a strategy in which you list all of your debts, the interest rate you’re paying on each and the minimum payment amount, then calculate how long it will take to pay them all off, one at a time. You can go in order from smallest debt to largest, or start with the debt with the highest interest rate, and then knock them out in descending order. There are many online calculators that can help you do this. Just search for “debt payoff calculator” and find out how soon you can get out of debt by snowballing.
4. “Guaranteed”
This can mean that something is risk-free — but it also might not. It all depends on who is making the guarantee and their ability to back it up. The federal government, for example, guarantees deposits at most banks up to certain limits, while insurance companies guarantee monthly payments from an annuity, usually over a lifetime. Use of this word should put you on alert to look at the famous “terms and conditions” that spell out the real rules that will apply.
5. Concentration risk
This is when you have too many eggs in one basket. It could be a single stock that far outweighs your other holdings, or a job that relies on a single skill set. It could occur with lots of mutual funds all owning stock in the same companies, or even a “can’t-miss investment” that involves many of your friends or family members. When risk is concentrated, failure or loss can take years to recover from. Always be on the lookout for this risk.
6. Expense growth
Knowing exactly where your money is going helps you determine whether you’re getting the real value you expect. Looking at expenses over time lets you see how much they’re increasing or decreasing, and sends you signals on when it’s time to change or eliminate an expense.
7. “Free”
Nothing is free. I once read that if something’s free, you’re about to become someone’s victim. I know that’s harsh, but “free” is the big hook to grab you and pull you into something where someone can make money off you. Think about the stock brokerage giving you “free” trades. They’re making money off you somehow, or they’d be out of business.
Learn more about Jim on NerdWallet’s Ask an Advisor
