Making Good Financial Decisions
In this post, we’ll cover a few of the biggest things people overlook when making financial decisions. Once you have a solid understanding of these concepts and have incorporated them into your own financial decision-making, you’ll find that you’ll be better able to not only make decisions that make sense, but also decisions that make cents.
The Time Value of Money
The time value of money is a basic concept in the field of finance that is taught to all students from the very beginning. It basically states that a dollar today is worth more than a dollar in the future because you can invest today’s dollar and have a dollar plus the interest you earned on that dollar in the future.
So if you were offered $100 today or $100 a year month from now, the time value of money says that you should take the money today. Now, if you were offered $100 today or $200 a year from now, it might be worthwhile to wait the year and receive an extra hundred dollars.
Logically, this would depend on the return that you’d be able to earn on the $100 if you took it today. If you could safely turn that $100 into $300 over the course of the year, then waiting a year for an extra hundred dollars wouldn’t be worth it.
When making decisions about where to put your money, it’s important to consider not only the level of returns you think you can realistically expect from the decision, but also how long it will take you to earn those returns.
If it is a large return, but you won’t get it for many years, it may be better to put your money into something with a lower return that, by compounding every year, will allow you to end up with more money than the original option you were considering.
Risk Associated with Returns
Another thing you should consider when making financial decisions is the amount of risk associated with each decision. The safety of the return you’re expecting out of a financial decision should be seriously considered before arriving at the final decision.
By risk, we mean the risk of losing money. There may be situations out there where the possibility of making a significant amount of profit are great, but if there is a substantial chance of losing everything you have, you need to question whether the opportunity is worth the risk.
An example of this is someone buying more house than they could afford and taking out an adjustable rate mortgage in order to be able to afford the payments. The primary risks associated with this would be that interest rates would rise causing them to no longer be able to afford their payments and them not having enough equity in their home to be able to refinance to a payment they could afford.
In this example, the buyers of the house should have acknowledged that the risks would likely have caused them to lose the house. This level of risk would have to have been weighed against the upsides of the decision (building equity over time, pride in owning their own place, etc) in order for them to have made a proper decision.
Of course, this is a simplified example, and there are several additional factors that could have gone into a decision like this in real life, but assessing the downside of your options is crucial to making decisions that will put you in a better financial position.
Opportunity Cost
Opportunity cost is an economic term used to describe the things you give up in order to do either something else or nothing at all. In other words, it’s what you sacrifice when you make a decision.
Let’s look at a simple non-monetary example.
Let’s say you just graduated from college and you have the choice of either entering the workforce or going straight into a graduate program.
If you choose to start working, your opportunity cost is the value of the graduate education you’re not taking advantage of. If you choose graduate school, your opportunity cost is the money you would have made in the workforce and the experience you would have gained.
The decision here obviously would depend on which option has more value to you and which one fits best into your plans for how you’re going to achieve what you ultimately want out of life. This is going to be different for everyone, as different people value each option differently and will have different personal goals they will want to achieve.
The concept of opportunity cost also applies to the option of not pursuing any of the available paths. In that case, the opportunity cost would be the value of what you didn’t do.
Opportunity cost is difficult to measure because you have no way of knowing exactly how things will turn out for each given option you have available.
The point we’re trying to make is that you need to be conscious of what you’re giving up to do what you’ve decided to do and what value that would’ve provided for you.
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