If you’ve been following my blog or have read my book, you know how much I dislike fancy financial jargon. Personal finance shouldn’t be complicated and both you and I deserve to have a clear understanding of what’s happening with our hard earned money. With this in mind and the fact that April is financial literacy month, I’m taking pause and breaking down 8 important money terms you may not know (but should). In digging into these not-so-sexy money terms, you’ll find that by understanding these foundational financial topics, you’ll only equip yourself to make better financial choices for today and the future. Here are some important money terms defined:
1. Asset Allocation
It literally means your money (asset) is being allocated (assigned) to different investment classes within your portfolio: stocks, bonds, cash, and mutual funds. More specifically, asset allocation determines how your assets are distributed within your investment portfolio. It is an investment strategy that adjusts the amounts or percentages you own in certain asset classes to balance risk versus reward based on your overall risk tolerance, goals and timeframe for holding investments.
2. Net Worth
Your net worth is literally what you own minus what you owe and it’s measured in dollars. Taking stock of this number initially gives you a great starting point for measuring your financial health and progress every six to twelve months. Calculating your net worth is simple and you can learn how here.
3. Compound Interest
This is your money’s best friend! Compound interest is when you earn interest on the money you invest and then earn interest on that interest. The longer this extra interest you earn on your investment has to grow, the more money your money can earn you over your lifetime.
4. Rule of 72
The rule of 72 is something we financial planners geek out over that helps us estimate how long it will take an investment to double its worth and over what time period. It’s a simple mathematical equation by which dividing 72 by the annual rate of return equals how many years it will take for your investment to double. For example, an investor who invests $1,000 at an interest rate of 6% per year will double their money in 12 years. (72 divided by 6 = 12)..
5. Rate of Return
Rate of return is the profit your investment earns over a particular period of time and can be a positive or a negative number (meaning you’re either making money or you’re losing it). The return is expressed as a proportion of your original investment over a certain time period (mostly a year, which is why you’ll see this number sometimes referred to as an “annual rate of return”). For example, if you invest $10,000 and it grows to $10,650 over 12 months, you’ve earned $650 on your $10,000. Your annual rate of return is: $650 / $10,000 = 6.5%.
I may or may not compare diversification to the numbers and types of shoes you own in my book, Work Your Wealth. You’re not going to have just one pair of shoes to go with all your outfits. Similarly, you shouldn’t have all of your money in just one or two holdings. Having a variety of investment types in your overall portfolio is diversification. It is a popular and recommended investment technique that helps to reduce risk and can provide more stable returns. Think of it this way: If you carry all of your eggs in one basket and you drop the basket, you’re out of luck for that awesome brunch you were about to have. If you carried your eggs in multiple baskets however, dropping one basket wouldn’t have as big of an impact as you can still rely on the others to help make that omelet!
7. Expense Ratio
This is a fancy term fund managers use that means fees… that you’re paying to them. Expense ratio is an annual fee an investor is charged by funds or ETFs to operate. The simple math is that the fund will divide its operating expenses by the value of the assets it manages and what’s left is the return to the investor. As an investor, you’ll want to know what the expense ratio is for investments you select so that there are no surprises. Aim for funds with expense ratios below 1%.
Inflation is a term that tells us the rate (percentage) at which prices for goods and services are rising. It’s expressed as an annual percentage rate. Basically, inflation can detour our finances if we don’t invest and grow our money because as things get more expensive, the dollars we have today don’t go as far. For example, if the price of your morning coffee increase from $2.00 to $2.05, that’s a 2.5% increase and what your money could have bought you in coffee yesterday, now won’t go as far. Prices tend to increase over time, which is why it’s important to grow your money and take advantage of things like compound interest. By getting a clear understanding of certain financial terms, you’re equipping yourself with the knowledge you need to make informed financial decisions. You can also check out more investment terms you should know here and here. Remember, if you’re ever talking with a financial advisor and don’t know a word they use, or concept or strategy they’re recommending –don’t ever hold back your questions. You should have questions and you absolutely deserve a financial professional who will take the time to make sure you have sound understanding around your finances.