Understanding finance


Before we delve into what are the basic aspects of finance required to be understood for investing ones hard earned money or switching over between investments we discussed with both the ‘Yes’ an ‘No’ categories of people who have answered about their knowing ‘Finance’.

Considering those who answered in the affirmative seemed to be overestimating their knowledge on finance. They tend to believe that they know more than what they actually know. Unfortunately, because of the perception, they are not open to re-considering their level of financial knowledge. This attitude has been proven by studies conducted in various countries such as Australia and the US. People tend to overestimate their knowledge in all areas of finance. For instance, in Australia, a survey revealed that 37% of the investors did not know that their investments could fluctuate in value. Similarly, in the US, 31% of the respondents to a survey did not know that they were paying to use the rollover credit facility offered by credit cards.

Now let us discuss about the people who said an emphatic ‘No’. They simply said “I don’t understand finance and I have no interest in finance�.

Those who answered in negative usually have very little idea about their financial positions-how their investments are doing, whether their money is being optimally used, etc. Unfortunately for them, until they decide to take interest, they will not progress towards a decent wealth build up.

The rest of the people who really understand finance said confidently, ‘Yes, I do. I manage my own investments and my finances are in good shape, thank you!’

We are giving here some basic aspects that one should know on finance for investing wisely with good returns. They are,

1. One needs to know how to study an investment opportunity. Simply reading numbers without understanding their implication will not help to make a sound decision. It is advisable to take a formal course on understanding and assessing investment opportunities.

2. Don’t take the word ‘risk’ loosely. The risk that one takes after studying an investment opportunity is different from the risk that is taken when one operates on recommendations and tips. The former kind of ‘risk’ is sophisticated, meaningful and controlled. The latter is merely a gamble.

3. Take meaningful risks to build meaningful wealth. Simply taking a minimal risk randomly will not help the investor to build wealth.

4. Debt investments carry two kinds of risks. Interest rate risk, the risk of interest rates moving up resulting in debt investments falling in value since it would offer lower interest than what would be available in the market. The second one is default risk that is the risk of not getting invested capital back. While government-backed schemes such as RBI bonds, post office schemes, etc. don’t carry default risk, they do carry interest rate risk. Debt investments such as company deposits, bonds etc., carry both kinds of risks. So remember debt investments are not risk-free.

5. Inflation should not be taken lightly. It plays a very important role in investments. It results in higher costs of living and lower real value of ones income over a time period. Investments made properly should earn a higher return than the inflation rate.

Finally, as a society, we need to understand that lower the level of financial knowledge, higher the chances of occurrence of scams and other unscrupulous financial doings by corrupt individuals. We need to protect ourselves from this by increasing our knowledge on finance.

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