Hover over each bullet point to get an overview of the topic as covered in the knowledgebase.
- Cash Flow Cash Flow
Making money represents all the ways you receive cash. These are your sources of incoming cash.
Spending represents the uses of your cash.
Together, making money and spending it represent the basic concept of cash flow - how money flows in and out of your accounts: Cash in, minus Cash out.
- Assets, Liabilities, and Net Worth (Equity) Assets, Liabilities, and Net Worth (Equity)When you apply for a loan, the lender will want to know your net worth, an indicator of your personal wealth. To understand net worth you have to understand assets and liabilities.
An asset is an item of economic value, which you own, and which is cash or could be sold for cash. The easier it is to sell the more liquid it is said to be.
A liability is money you owe or will owe, for example having paid a deposit for a holiday the balance is a liability. Liabilities are almost always 'liquid', i.e. payment has to be made in a short amount of time.
Net worth is assets minus liabilities.
- Cash Cash
Cash is an integral part of personal finance. It is the only asset class that doesn't pose any capital risk - meaning that you won't lose any actual money by placing your money in 'cash.'
However, that's not to say that there aren't any risks with cash. The spending power of money falls if inflation is higher than the interest rate you receive. This is known as inflation risk.
Easily accessed cash (liquid cash) as an emergency fund is a vital starting point of personal finance.
- Investment Securities Investment Securities
These are investments such as corporate and government bonds (loans to businesses and government that make a regular and fixed interest payment) and shares (equities) that are held for the regular payments they make.
Their logical value (as opposed to the value the market may place on them - which is not always rational) depends on that regular series of payments discounted over time. See Time Value of Money
These assets are traded minute by minute, second by second and so are very 'liquid'. That reduces the risk of ownership as there is always someone willing to buy, although not necessarily at the price you would like. So they are more risky than cash, with corporate bonds less risky than shares and government bonds (usually) less risky than corporate bands.
- Capital Assets Investment Property or Personal Use Property.Capital Assets Investment Property or Personal Use Property.
Capital assets, typically property, are not traded as are investment securities and take longer to sell, so not 'liquid' assets. This makes then riskier as they may have to be sold at a significant discount (far below their actual value).
Again the value of such an asset, other than for personal use (e,g. the family home), is based on the flow of payments that derive from such an asset. In the case of property that is rents. See Tim Value of Money.
However, since property can be used a security against a loan (i.e. a mortgage) there are economic reasons in an economy where debt is the main driver of GDP why residential property may rise in price faster than rents would suggest.
Managing Assets and Liabilities
- Borrowing, Debt, Loans, and Credit Borrowing, Debt, Loans, and Credit
Everyone borrows during the course of their lives, but there is a huge difference between borrowing to acquire an asset that delivers a financial return, e.g a house so as not to pay rent (paying rent if living on a pension can be very undesirable) and borrowing to fund a lifestyle that is basically unsustainable.
Most loans are personal loans, i.e. you are personally responsible for re-paying the loan. Failure to re-pay a loan can have serious personal consequences.
Some forms of borrowing are very expensive, .e.g. a credit card, and some are exorbitant, e.g. pay day loans. So it is always a good idea to plan your borrowings and not be forced into a loan due to circumstance. This is why an emergency fund is so vital. See Cash.
The type of loan requested (secured against an asset that can be sold to pay the debt or unsecured) and your credit rating, will affect the interest rate offered on your loans. Your credit rating being dependant on how well you managed previous loans.
Key Investment Concepts
- Setting Goals and Planning Setting Goals and Planning
The main personal finance goals are growing your Net Worth and managing Cash Flow.
Net Worth = Assets - Liabilities
Managing cash flow enables the growing of Assets by managing the reduction of Liabilities and so increasing Net Worth,
Cash Flow = Income - Expenses.
- Monitoring Your Financial Health Monitoring Your Financial Health
We provide a number of financial management tools. From the basics of understanding and managing your spending so as to provide funds for investment, to valuing a proposed investment (the value of an investment often being hugely different to its price) and understanding and managing the risk a portfolio is subject to - value at risk.
- Insuring Your Life and AssetsInsuring Your Life and Assets
Insurances are meant to ease the financial pain of a number of life's misfortunes from death to losing your job.
Some or, possibly, all of them could be replaced by an emergency fund. However, initially at least, it is almost certain that a choice needs to be made between paying insurance premiums and building up an emergency fund. That means, how much should I save in my fund and how much spent on insurance premiums. The amount spent on premiums depends upon how much cover makes a given individual feel safer.
Like anything, the value of the policy needs to be determined. The value being whether the likelihood of the insured risk occurring and the financial consequences should it occur.
- Living and Retiring ComfortablyLiving and Retiring Comfortably
To retire comfortably, i.e. to have sufficient income in retirement, means making investments that give the best chance of an adequate return. That test of adequacy being based on both the risk of the investments and individual lifestyle.
To make those investments means saving during your working life, which will have an impact on consumption and hence lifestyle over the large part of your adult life.
So striking that balance is very important.
Making Your Money Grow
- Time Value of MoneyTime Value of Money
This concept reflects the fact that money available now is worth more than the same amount in the future due to its alternate uses as either having potential earning capacity or that it can provide the individual with 'utility' - the value that is derived from spending on something that gives the individual pleasure.
This core principle of finance holds that, provided money can earn a return, any amount of money is worth more the sooner it is received.
For example, assuming a 5% interest rate, £100 invested today will be worth £105 in one year (£100 multiplied by 1.05). Conversely, £100 received one year from now is only worth £95.24 today (£100 divided by 1.05), assuming a 5% interest rate.
This concept forms the basis of the basic valuation technique for an investment that delivers a series of returns (e.g. bond interest payments or share dividends). Since those returns are paid at different times (typically over years) they need to be discounted (reduced in value) to allow for the time value of money. This is known as discounted cashflow.
- Return on Investment (ROI)Return on Investment (ROI) The extra value earned from an investment.
There are three type of ROI:
Interest Income, Dividends and Capital Gains.
- Rate of Return Rate of Return
This is the gain or loss on an investment over a specified period and is expressed as the annualised percentage increase over the initial investment cost. Gains on investments are considered to be any income received from the security plus (minus) any increase (decrease) in the value of the investment.
The rate of return can be used to measure virtually any form of investment, from real estate to bonds and stocks to fine art, provided the asset is purchased at one point in time and then produces cash flow at some time in the future. Financial securities are commonly judged based on their past rates of return, which can be compared against assets of the same type to determine which investments are the most attractive.
Annualised values are used so as to be able to compare returns over time periods of different lengths on an equal basis. This conversion process is called annualisation.
The risk-free rate of return is a theoretical rate of return of an investment with zero risk and represents the interest an investor would expect from an absolutely risk-free investment over a specified period of time.
In practice no investment or saving is risk-free, even cash on deposit suffers from inflation risk as the interest rate may be less than inflation and so the risk is that the purchasing value of savings is at risk. However, a benchmark is required so as to judge those investments where capital is at risk and the typical benchmark is that of bonds issued by governments with a good credit rating. A number of agencies issue such ratings.
- Risk and Return Risk and Return
Returns cannot be considered in isolation and have to be thought of in terms of two aspects of risk - how risky is the investment and what is the individual's tolerance for risk.
There are mathematical approaches to assess the risk of an investment by calculating just how volatile are the returns from a given investment.
We have tools to assess individual risk tolerance based on a series of questions.
- Economic InfluencesEconomic Influences
The relationship between the economy and businesses operating within that economy can be considered as being very similar to that between a piece of water (lake, river, etc.) and fish. If the water is polluted then, no matter how fundamentally strong the fish, fish will suffer.
Conversely, if the water is environmentally sound fish will generally thrive, although some individual fish will always thrive less than others.
The fundamental economic conditions akin to being 'environmentally sound' all relate to demand and whether rates of return compensate for risk.
The financial knowledgebase is backed up by an economics knowledgebase into which the use can dip whenever appropriate.
- Economic IndicatorsEconomic Indicators
There are a very large number of economic indicators from such basics as the rate of inflation to obscure technical measurements concerning money supply. They all, directly or indirectly, connect with each other like jig-saw pieces to give an overall picture.
The ones of immediate interest to individuals will depend on their circumstances. For example, a retired couple living on a combination of pensions and long-term government bonds should be looking for different things than a stock trader who rides the waves of the business cycle.
The gross domestic product (GDP) figures are especially relevant to equity investors who are focused on corporate profit growth. Because GDP represents demand in the economy.
In addition to current indicators there is always a need to form an opinion as regards the future of those indicators from other indicators. For example, if inflation is rising then that means interest rates are more likely to rise rather than fall and when interest rates rise domestic demand falls, which, depending on how much the economy relies on domestic demand, affects GDP.
The trick is deciding whether to ride out any storm the indicators seem to foretell or find a shelter.
- Savings and Debt Investments Savings and Debt Investments
Cash savings are generally confined to an emergency fund. It is vital to have such a fund to provide easily accessed (liquid) funds to cover unforeseen circumstances such as a sudden home repair or a temporary loss of income. No investments should be sought until an adequate fund exists.
Debt investments come in the form of tradable corporate and government bonds. High quality corporate bonds can be considered as safe as government bonds. They pay a fixed return over a fixed period and form a useful part of a portfolio as a balance to riskier shares.
- Equity InvestmentsEquity Investments
The riskiest form of an investment but that risk can be reduced by understanding the fundamentals that indicate a business that is performing well one that is worth buying a share of.
As an alternative to buying individual shares there are various financial products that group together individual shares under a common identity, e.g. FTSE 100. This is a means of balancing risk across individual businesses and is highly effective means of risk management.
- Managing a Portfolio Managing a Portfolio
Portfolios are means of balancing risk and reward. The constituent parts should work in such a way as to keep the overall rate of return from the portfolio as stable as possible, bearing in mind the individual's attitude towards risk and return.
There are various means of using the risk associated with the constituent parts (their volatility) to determine what should be the overall risk of the portfolio.