WATER: Want to manage your money better? Know these key investment principles
Dubai: Successful planners – those who stuck to their initial plans – achieved an average total net worth three times higher than those who didn’t plan, according to research and polls.
The bottom line changes when you have more cash to manage. Once you’re in the six digits, these fluctuations in interest rates and dividend yields can quickly add up to real money, so you’re keenly interested in small changes. Although your cash reserve is heavy, preservation and liquidity are still crucial.
However, understanding how to control your finances is a crucial life skill. If you understand the basics of good financial management, you will be better prepared for the future and more financially secure.
There are a few fundamentals that can be used to study finance, including understanding the time value of money, knowing why higher returns come with higher risk, and understanding how diversifying investments helps reduce overall risk, among others. other.
Relationship between money and time
A fundamental principle of finance is that money has a time value. In other words, a dirham earned today will be worth more than a dirham earned in the future. Hence, money can be invested in order to earn more money.
This principle concerns the value of money, this value decreases over time. The value of Dh1 in the present time is greater than the value of Dh1 after a certain time or years.
So, before investing or taking funds, one should think about the rate of inflation of the economy and the required rate of return must be greater than the rate of inflation so that the return can make up for the loss suffered by the economy. inflation.
Inflation is the continuous increase in average price levels of goods and services. For example, Jim Smith buys a loaf of bread every week for Dh3.50, but if the price of the same bread goes up by Dh0.30 due to inflation, Jim may not be able to afford the bread anymore. ‘to come up. .
Relationship between risk and reward
The next principle of finance explains the relationship between risk and reward. The higher the reward, the greater the risk.
The principle of risk and return indicates that investors should be aware of both risk and return, because the more risk increases rates of return and decreases risk, lowers rates of return.
To ensure optimal rates of return, investors should measure risk and return by both direct and relative measurement.
This principle suggests that making a high risk investment is a waste of resources if the return is low. For example, if Jim has the choice of investing in an unsecured bond, the risk will be low for the secured bond (such as a government bond) and high for the unsecured bond.
What is an unsecured bond?
An unsecured bond, or commonly known as a “junk bond,” is a bond that is not highly rated, which means that there is a good chance that there will be a default on the investment.
If Jim invests in the junk bond, he may not get paid. On the other hand, the government guarantees that the holder of a government bond will get their money back.
Secured bonds are also considered low risk because they are backed by an asset, such as a car or a house, which a lender can claim ownership of if the borrower defaults on the loan. This is important because it reduces the risk that the investor will lose his earnings.
The relationship between risk and reward demonstrates that low risk offers low return while higher risk offers higher return potential.
Diversification of investments and minimization of risks
The next principle of finance states that the diversification of investments, or the spread of investments and risks over many different companies, can reduce the overall risk of the investor. This is important because the lack of diversity of investments can increase the investor’s market risk.
This principle makes it possible to minimize risk by building an optimal portfolio. The idea of a wallet is to never put all of your eggs in one basket, because if it falls out all of your eggs will break, so put the eggs separating them into a different basket to minimize your risk. To ensure this principle, investors should invest in risk-free investments and risky investments so that the risk can ultimately be lower.
For example, if Jim only invests in oil stocks and there is a shortage of oil in the market, all of his holdings will be affected. However, if Jim diversifies his portfolio to include grocery stores and record labels, he can expect more stability as his risk is spread across the market and not concentrated in a single type of business.
Do you know how the markets affect your money?
Another principle of finance states that financial markets are efficient in pricing any asset or security. The market tracks a company’s news, future forecasts, supply and demand, and other factors.
Based on historical information, this principle may not be the best strategy for investors, as financial markets are efficient on their own and the financial environment is constantly changing.
Another key principle of the financial market is that the goals of a fund manager and shareholders may differ. The manager does what he thinks is best for the business.
On the other hand, the shareholder wants the value of the share to increase so that they can sell the share at a higher price in order to maximize their wealth.
Role of the company’s cash flow, profitability and liquidity
The principle of cash flow mainly deals with cash inflows and outflows, more cash inflow in the prior period is better than subsequent cash flow by investors. This principle also follows the principle of time value, which is why he prefers more benefits earlier than benefits in later years.
The principle of profitability and liquidity is very important from the point of view of the investor because the investor must ensure both the profitability and the liquidity of everything he invests.
Liquidity indicates the marketability of the investment, that is, how easy it is to obtain liquidity by selling the investment. On the other hand, investors should invest in such a way as to ensure profit maximization with a moderate or lower level of risk.
What role does the company’s reputation play in your investments?
Reputation has a significant influence on an investor’s decision whether or not to invest in a financial instrument. A financial instrument is a legal document representing the right to receive an asset such as cash, a contractual right to deliver or receive cash, or some other form of tradable equity.
Reputable companies will get more people to buy their stocks. Companies with a bad reputation can have a hard time convincing people to buy stocks. For example, investors prefer to buy Microsoft shares rather than Enron.
(Enron was a US-based energy company that committed one of the biggest accounting frauds in history.)
In the past, Enron’s lack of ethical behavior has called its reputation into question. Ethical behavior is behavior consistent with what society, businesses and individuals generally regard as good values.
Investors are wary of companies like Enron, which has manipulated its financial statements to make its position appear better than it was. This type of unethical behavior costs investors a large sum of money over a short period of time.
Therefore, Enron ceased operations when its fraudulent activities were discovered.
How hedging and loans work on your investments
The principle of hedging tells us that we must take out a loan from the appropriate sources. For short term fund needs we have to fund from short term sources and for long term fun needs we have to manage fund from long term sources. For fixed assets, funding must be secured from long-term sources.
What are fixed assets?
Fixed assets, also known as long-lived assets, property, plant and equipment, or property, plant and equipment, is a term used to account for assets and property that cannot easily be converted to cash. Fixed assets are different from current assets, such as cash or bank accounts, because the latter are liquid assets.
Finally, if you have a basic understanding of finance and its principles, you will be able to make financial decisions effectively – and there is a greater possibility of becoming bigger and reaping bigger returns.