Investing, saving, and spending money requires that you make informed decisions. It's the only way to ensure you take responsible steps to control your finances. And to stay in control, you must familiarise yourself with financial concepts that guide your decision-making process.
These concepts serve one primary purpose: to keep you financially literate. And when you are financially educated, you are likely to make better decisions. You can increase your income and get more out of your money.
With that in mind, this article will dive into seven financial concepts every Kenyan needs to know. It will also explore how these concepts can be helpful when you make your next big decision.
Interest is the extra amount you earn when you save money in a bank account, SACCO, MMF, or other saving vehicles. It is also the amount a lender charges you if they give you a loan. Understanding how this concept works can help you use it to your advantage.
For example, understanding the type of interest rate you are paying can help you tell if a loan is too expensive. You'd pay more to a lender offering a flat rate interest method and save money when you borrow from a lender with a reduced balance method.
Regarding savings, you can leverage compound interest to get the most out of your money. Compound interest is the interest you earn on top of your interest. This concept allows you to grow your money faster as you earn from your original investment and accumulated interest. It is ideal when saving for long-term financial goals like retirement.
Net worth is important to understand as it is a good indicator of your financial well-being. It allows you to measure where you stand. If you are constantly in a negative position, that is an indicator that you are financially unhealthy. Net worth is the difference between your assets and liabilities.
To understand your net worth, you should first grasp these two concepts:
Assets: These are all the things that you own. It can be a house, land, a car, education certificates, skills, investment accounts, or a stake in a business.
Liabilities: These are things that you owe. This can be a mortgage, unpaid auto loan, or any other consumer loan, unpaid taxes, unearned wages, etc.
To calculate your net worth, sum up all your assets with monetary value and subtract what you owe. For instance, Eliud owns a piece of land upcountry with a market value of Ksh350,000 and investment accounts worth Ksh150,000. His total assets stand at Ksh500,000. But Eliud also has a car with an unpaid loan of Ksh300,000 and still owes HELB him Ksh32,000– making his total liabilities Ksh332,000.
Eliud's net worth will be the difference between his assets (Ksh500,000) and liabilities (Ksh332,000). That equals a net worth of Ksh168,000.
This refers to the rate of change in prices. Inflation causes the prices of services and products to increase, lowering the purchasing power of your money. It is caused by various things but mainly market risks and policy changes.
Understanding inflation is crucial as it guides how you invest and spend your money.
If prices are rising, it could make better sense to purchase now. For instance, if you have saved Ksh1m to buy a piece of a plot, you won't save that money in a bank account and purchase the same plot next year. That's because you know the land will cost significantly more then. So you buy now while you still can.
Considering its effects on the purchasing power of your money, inflation can lower the value of your savings and pension. This is why, when investing, it's vital to choose vehicles that keep up with inflation rates, such as real estate.
Inflation also leads to an increase in interest rates. This can cause you to pay more for loans you owe. If you have a variable interest rate on your mortgage or car loan, you could pay more if the interest rate goes up. You can protect yourself from such phenomena by choosing a fixed-rate lender.
This refers to how quickly and easily you can sell your assets without experiencing losses. There are two types of assets:
Understanding liquidity can help you decide how you invest for different goals. For instance, when saving for emergency funds, you want to keep your money liquid assets. And when saving for your retirement or kid's college fund, you can put the money in a long-term investment like treasury bonds.
This refers to the increase in the value of your asset over time. It is the difference between the current market price of the assets and the original price.
When investing, you will realise gains in three different ways. Some investments appreciate, i.e., grow in value, and some generate income. Others, like dividend-paying stocks, do both.
The type of investment you choose will depend on various factors. For example, assets that appreciate in value are often less risky than those that generate income.
Here is an example of appreciating and income-generating assets:
Investor A and Investor B each have Ksh1,500,000. Investor A is interested in income-generating assets, while Investor B prefers growth assets.
Investor A: He bought a matatu that could guarantee him Ksh6,000 per day. At the end of three years, after deducting all operation costs, he made Ksh2,700,000. He sold the now-old vehicles that have depreciated for Ksh500,000. That could bring his total earnings to Ksh3.2m. If you minus the initial capital of Ksh1.5m, his profits will be Ksh1.7m.
Investor B: He chose a different path and bought a plot with his Ksh1.5m. Three years later, the plot is worth Ksh3.2m. If he were to sell it today, he could make a profit similar to investor A's.
While assets that appreciate can contribute to your net worth, you don't benefit from their increase in value unless you resell them. However, you can leverage them and use them as collateral. You can use the money to start a business or invest in income-generating assets.
You must have heard the phrase, "don't keep all your eggs in one basket." It could never be more applicable than when it comes to where you put your money. If you want to prevent yourself from suffering devastating losses, you should diversify your savings and investments.
Diversification is the process of spreading your money across various assets to reduce the risk of losing all your money if one investment goes under.
If, for instance, you keep all your savings in one SACCO and, due to poor management, the SACCO fails, you will instantly lose all your money. But if you spread your savings across different savings accounts, SACCOs, MMFs, and bonds, you will limit losses if one fails.
Diversification does more than protect your money; it can also increase your returns. It achieves this by ensuring losses you experience on one investment vehicle are canceled out by profit from another.
When diversifying, allocate your assets across different investment classes. Have liquid and illiquid investments; invest in growth (appreciating) instruments and income-generating ones. It is also essential that you factor in the time horizon and your investment goals when diversifying. Finally, constantly rebalance your portfolio to ensure you don't sway from your plans.
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Any financial step you take will involve some level of risk, which is why you must understand the concept of risk tolerance before making a decision. Risk tolerance refers to the willingness of an investor to take risks and the ability to withstand market volatility to achieve their objectives.
Your risk tolerance will guide how you invest and the type of financial risks you take. Investors can be classified into three categories depending on their risk tolerance:
The five factors that will help you determine your risk tolerance include:
Understanding these concepts will help you become less susceptible to losses, ensure you don't miss opportunities, and help you build wealth. But as with everything regarding personal finances, you will have to dig deeper to understand them completely.
A first step could be consuming financial literature or enrolling in a personal finance class. When you try to implement this concept without enough knowledge, it might backfire and cause you losses. If a concept is proving too hard to grasp, you should get help from an expert. You can talk to a financial advisor to break it down for you.