Short Guide To Basic Finance Concepts

Do you ever wonder what an MBA knows that you don’t know? Is it really all that helpful to your career? Well, I believe that knowledge truly is power — even more so in job potential. Especially knowledge of basic finance concepts. So with that idea in mind, I put together a basic financial literacy guide to help you strengthen your business savvy. I also threw in a few economic concepts for some extra MBA flavor.

Although it took me two years to get my MBA, most likely you don’t need all that. In fact, I haven’t used a lot of what I learned. But there are some basic finance concepts that absolutely can help. I want you to never again feel that others can take advantage of you for what you DON’T know. And you may even surprise a few people with what you do know!

Let’s start with how banks work

We all know that you can put your money in a bank. And if it’s a savings or checking account (demand deposits), you can use it whenever you need (demand) it. But they don’t offer you a safe haven just out of the goodness of their hearts. And your money isn’t really just sitting there.

Do you ever wonder what happens to your money? And what the bank gets in return? Drum roll. Enter the lending concept. Banks use your money to make money for themselves by creating all kinds of loan products.

If you remember the film It’s a Wonderful Life, there’s a scene where Jimmy Stewart is trying to stop a run on the bank. He tells the frightened customers:

No, you’re thinking of this place all wrong. As if I had the money back in a safe. The money’s not here. Your money’s in Joe’s house…

Obviously, Jimmy Stewart’s character was explaining mortgages. And they are a good example of how a bank really operates.

So where does your money go?

Your money doesn’t just sit there resting, even if you see it in your checking or savings account. And even though you can get it when you want it. But meanwhile, the bank puts it to work in all kinds of bank products, earning them money. Ideally more money than they pay you.

In a way, they are creating money that goes into the economy and helps create even more money. Please note that this is not the same as trickle down theory, where rich folks get the money so they can then invest it. And, as the theory explains, that investment will eventually reach the rest of us.

Unfortunately, it doesn’t always make it all the way down. Although there are ample arguments on both sides. An alternative theory is to give the money to the poor and middle class first, since they are more likely to spend it. This puts it directly into the economy — like an economic booster shot.

Sorry for the short detour. If you want to know more about how banks use your money to in effect “create” more money, this International Monetary Fund article goes into a bit more detail (scroll down):  How Banks Create Money.

What about bank interest rates?

As a bank customer, you want to earn as much interest as possible from your deposits. And you want to pay the lowest interest rates possible on any debt you have. [Credit cards, lines of credit, Home Equity Loans (HELOCs), personal loans, small business loans, mortgages, etc.]

Of course, banks make it their goal to do exactly the opposite. Profit is truly one of the most familiar of all basic finance concepts! And the larger the gap between what the bank pays for deposits and what they charge for loans, the more profit they make.

Now let’s look at an example

Say you decide to put your money in a bank CD at 1%. And the bank turns around and uses that same money to make a 5% loan. They wind up earning about 4% on the money you originally deposited. And they can use any money that gets paid back early to make even more loans.

So to make sure you maximize your own earnings, you want to keep a close eye on what your money gets you. And an even closer eye on what you’re paying to borrow money, since some loans have rates that change.

Ideally, you want the smallest gap possible between interest income and what you pay to borrow. Or even better no gap. And maybe even coming out ahead if you earn more from your money than you pay in interest.

Where do these bank interest rates come from?

Well, there are many factors, but the root of that number is usually the Fed Funds Rate. This is the rate banks charge each other for overnight loans to meet their legal obligations. (The amount of their total assets and liabilities determines the percentage they need to keep.).

This amount varies and often needs a little tweaking, depending on the market activities of the day. If a bank falls short, they borrow. If they have extra, they lend. Then these rates, in turn, influence other rates throughout the financial marketplace.

Some basic bank products

Most common deposit products

• CDs — A type of “time deposit” with a set maturity date, such as 6 months, one year, two years, etc. The further out the maturity date, the higher the interest rate. Some have minimum amounts you need to invest. You also need to watch out for automatic renewals.
• Savings accounts — A basic deposit account to park your money if you want to keep it liquid — meaning you have access to it any time. Interest rates most banks pay for savings now are very small, although probably more than checking accounts. So for money you don’t need in the near future, look at bank CDs or higher-paying market type investments.
• Checking accounts — Another liquid bank account. But you can write checks. Some even pay interest — although not much. Nowadays, with online accounts, you can have automatic payments deducted from checking or savings, eliminating the need for most checks. But a useful feature of checking accounts is the overdraft feature, if you set that up. Personally, I still like my checking account for active transactions. But make sure you ask about any fees.
  
• Money Market deposit accounts — These are NOT the same as money market investment accounts, which are money market funds. They usually pay less than a savings account, but let you write a limited number of checks. They are bank products so they are FDIC insured, while money market funds that you get through a broker are not.
• Negotiable order of withdrawal (NOW) account — These were popular for a while, but are rarely seen nowadays. They were developed before you could have interest-bearing checking accounts. But now you can, so you can pretty much ignore this.
  

NOTE about FDIC insurance: Bank deposit products are all FDIC insured as long as they are issued by an accredited bank. That means if the bank fails for any reason, your money will be given back to you by the FDIC (Federal Deposit Insurance Corporation).

The only thing you need to know about that is there is a $250,000 limit per product. So if you have more money than that, you can open more than one deposit type of account. Each account will be insured up to that limit.

What about bank brokerage?

Some banks also own brokerage firms. And, unlike bank deposit products (which may have fees), there are costs when you buy and sometimes when you sell. Also, when you buy market products like stocks and bonds from a brokerage firm, even if it is part of a bank, there is NO FDIC insurance.

Meaning there is no guarantee if things go wrong. Although there actually are some special types of bonds that do have guarantees. You need to ask if yours do no matter what kind of broker you use.

And remember, unlike bank deposit accounts, the trade-off for higher (potential) investment earnings in the market is that you can lose money. Even all of it. So do your research, and invest at your own risk. But, since we’re talking basic finance concepts, that’s what the market is all about anyway.

NOTE: While in theory money market funds can also lose money, usually they at least hold on to what you started with. One friend of mine sees them as his long-term investment choice, because he would rather not worry about the ups and downs of the stock market. (And he also chooses not to think about how much inflation eats into money over time.)

Still, for me, they’re just a temporary place for funds I want to invest at a later time. And so in that case, I may as well stick with bank deposit products that are FDIC insured. The difference in interest, at least at this time, is negligible.

Basic finance concepts of investing

Clearly, there’s no way this one article can give you all you need to know. Any of these topics can fill a book. And eventually, I will have many more articles to help. But, for now, here are some investment basics to help you feel more comfortable with the topic. And with your own investments.

Earning money with your money

Any investment, whether bank products, stocks, bonds, real estate, or even owning part of a business, come with an expected rate of return. That’s the amount you wind up making on your money. For example, let’s say you invest $1000. If at the end of a year it’s now worth $1050, your rate of return is 5%.

With investments that have a higher risk you might get higher returns. But the word MIGHT is key here. As risk goes up, there is always a chance your investment may turn into dust. And don’t forget the commissions and fees no matter what the risk level.

So that guaranteed 20% return the nice man on the phone is promising you comes with a risk that you could lose all. Although HE still gets his commission — or all the money if it’s a complete scam. Think Bernie Madoff.

So what about something safer?

As we discussed, there are bank deposit products that pay very little. A safe place to park money if you want to protect the core amount. And many super wealthy people also own tons of (US government) treasury securities, along with other relatively low-paying safe investments.

They feel more comfortable protecting their principal (amount you start with), and getting a guaranteed lower rate. But they can afford not to go for huge risk. One percent of $10,000,000 is $100,000! But one percent of $100,000 is only $1,000. Still, better than nothing — and you get to sleep more peacefully at night.

But for those of us with a lot less money, it’s tempting to try to earn more on the little we have. The idea is to keep our nest egg growing and to help counter future inflation. So we loom for other investment options, that match how much risk we can take.

Portfolio theory to the rescue

Portfolio theory tells us not to put all our eggs in one investment basket. No matter how tempting the basket may seem. Spread it around (municipal bonds, corporate bonds, stocks, treasuries, funds, real estate) in case you break an egg or two. Or in case you have to hold on to some of the eggs … er … investments for a while. Until they recover from market downturns or they mature, as in the case of bonds.

⇒  Portfolio Theory: Why Diversified Investing Is So Important

 

What about mutual funds?

Mutual Funds also allow us to invest in a group of (hopefully diversified) stocks and/or bonds managed by (hopefully) experts. This builds portfolio theory into the mix. You might also want to increase the number and types of funds you own, to add to your diversification.

But, please note that each fund has management fees built in. And many charge a fee (load) to buy and/or sell. This cuts into any profit you might make. It’s a good idea to check out this stuff for yourself – no matter how much you like your broker. Morningstar.com is a good source.

In contrast, no-load funds (my favorite) charge no in/out fees, but may have large less-obvious management fees that confuse the issue. And affect how much you’re really going to make. But some do have very low management fees. Again, check this out carefully, so you know what you’re really getting.

What about index funds?

Many experts suggest index funds as a good way to go to avoid worrying about picking the right stock or fund. Even the experts invest in them. They’re designed to follow broad market indices like the Standard & Poor’s 500, the DJWilshire 5000, the FTSE 100 (British stocks), etc.

Over time, with a rising market, you should do fine. But as with funds of any kind, what goes up can also go down! So remember to ride the ups and downs like a pro. Not sweating the lows–  and not getting too excited about the highs. Well, maybe a little.

A little more about bonds

Bonds can be corporate or government and basically act as a means of financing debt. For instance if a city needs to build new roads, they might issue bonds that can be insured or uninsured. Companies also issue bonds to help finance their operation.

What you need to know about bonds is that interest rate and price have an inverse relationship. Meaning if rates go up in the world of financial markets, the price of the bond goes down. So let’s say you originally bought the bond at par (price when issued). But now interest rates have gone up a percent, your bond will be selling at less than you bought it for.

Why is this ok? Because bonds usually have a due date (maturity date). So if you hold your bond to term, you get full value plus all the interest you’ve earned. And if interest is paid along the way, you already have it and may be earning even more with it.

The secondary market effect

But bonds also have a secondary market, as do stocks and certain other investments. And so they can be traded. Bonds also provide portfolio balance for stocks, since a poor stock market may be a good bond market.

It’s good to have some of each investment type. This way you can weather market downturns more easily. Also, as you get closer to retirement, you may want to have more bonds than stocks. Why? Because they are usually less volatile. And you can hold out until maturity for full value.

NOTES:  This is not true for bond FUNDS in a rising interest rate economy, since bond fund prices can get hammered. (Because of the reverse effect we discussed earlier.) And although the individual bonds they hold can mature and then get replaced with new ones, the fund itself doesn’t ever mature.

Also, what about the proportion of bonds versus stocks? Traditional wisdom says much more bonds than stocks at retirement age. But, if you have 20-30 years ahead of you when you retire (and enough money) you probably can still keep a lion’s share in stocks. At least for a while. Just think about the timing of your future expense needs. And the possibility of a down market lasting for at least a few years.

⇒   How Much Money Do You Need To Retire?

 

Some basic finance concepts for stocks

So what is the Stock Market? Most simply, it’s a mechanism to buy and sell stocks (shares in companies). While some companies are private – meaning shares are not available for the public to purchase – for public companies it’s a way of raising money to finance their operations.

Although the stock market can be exciting. And people like Jim Cramer on his show Mad Money make it seem like you can make money hand over fist. If it were that easy there would be a lot more people on Wall Street who wouldn’t need to work any more.

The market goes up — and it also comes down. So don’t get suckered by an up market that seems like it can’t end. It can and it will. But, at some point, it will also be ready for another climb.

Back to our friend diversification

That’s why smart investors diversify. They put some of their money in safer investments. Some goes into moderate risk and growth. And then they use some smaller proportion of their money to gamble.

Even with a rising market, you can be holding a dog of a stock that never barks again! But that said, the market certainly offers people an opportunity to make more than the piddly interest rates most banks offer.

Just know that, even though it will eventually go up again, there is no guarantee of value at any given time. So, once again, keep those investment eggs spread around.

Some basic concepts of economics

Present value – Most easily represented by the phrase “A dollar today is worth more than a dollar tomorrow.” And the reason for that is the dollar today can ideally be earning interest. Whereas a future dollar earns you nothing for sure and loses out on being put to work NOW. This loss is called opportunity cost. Another one of our basic finance concepts.

Supply and demand – When there isn’t enough of something to meet the demand of what people want, businesses can charge more. Like when you see gas prices go up at the pump. Economists explain it by saying that gas demand exceeds gas supply. Therefore the price they charge goes up.

But when demand falls, companies can’t raise the price any more. At least in theory. So, if demand falls sharply enough, they would have to lower it until demand picks up again. Of course, things like price manipulation and greed are not part of the simple economic model.

Price elasticity — A related concept that helps explain how high a price can go before people stop buying. Returning to our gas example, potentially there should be a good deal of upward give (elasticity). Since as a nation we highly value our ability to drive wherever and whenever we want. So left solely to the supply and LOTS of demand principle, considering how strong the demand is, gas could keep going up and up.

But today we have almost instant awareness of rising gas prices thanks to the internet and 24/7 media. And because market forces are so connected, gas prices can only go up so far before people start screaming. And showing their displeasure by buying less. Less demand, prices ease. So the elastic band can only stretch so far.

Cost-benefit analysis — Both a finance and economic concept, cost-benefit analysis is a model for decision-making. You know it better as a pro-con list of sorts. But in this case you assign actual values / weights to each part of the analysis to see which side outweighs the other.

As a simplified example, you may be weighing the cost-benefit of buying a car. On one side of the analysis, you work hard and really want a car. It will also save you time since it’s readily available. And you’ll save money on other forms of transit.

On the other side, you need to use your savings (or take on debt) to buy the car and insurance. You also need to pay for gas and maintenance. And you’ll have to find parking (or pay for it) wherever you go. Plus, your job is on a bus route. Turns out the cost of owning is much higher than not owning.

A lesson that applies to all economic analysis

The example above gives you a general idea of how to do cost-benefit analysis. You assign value to each part and then see which side comes out the winner. But a good cost-benefit analysis isn’t just about the dollar value. It’s the weighted value of each cost or benefit.

So in this case, the economist’s question might be: “How much weight do you put on really wanting a car?” Does the personal benefit of that outweigh the heavier monetary costs for you? In any economic analysis, the real art is how much weight you assign to each individual part of your formula.

More articles to help

There’s no way I could cover everything you might need. But I hope this covered a lot of useful basic finance concepts territory. For more in-depth articles on these topics, you might enjoy some of these:

I Want To Learn To Buy Stocks for Myself

Difference Between a Roth IRA vs Traditional IRA

Learning to Make Friends With Your Money

 

Retirement Reality: What Happened To The Dream?

How Your Relationship With Money Can Affect Your Life

Is Your Fear of Numbers Chasing Away Things You Want?

 

Sample Cash Flow: How To Create a Cash Flow Spreadsheet

Sample Budget: How To Create a Budget Plan Spreadsheet