MythTip: Think Like A Financier!

Personal finance is really not all that difficult. In fact, most people could probably maintain their finances in good health without any assistance whatsoever if they had only been taught the subtle nuances of money and the implications of various cash flows. In this MythTip, we’ll take a look at one way in which you can gear your mind to think like a finance professor.

Apples to Apples

In another post, I mentioned the fact that sometimes financial calculations can give skewed information because of the incompatibility of the cash flows being used. This is the first, and perhaps most important rule of financial understanding: you must compare apples to apples.

For example, let us say that you have the opportunity to save $10 per month. Many people might say that $10 is not very much money. But not the financier. The financier may profitably take a different perspective. What if that $10 was considered as interest placed into a high-yield savings account? How would the effective interest rate be changed if the account were to receive an additional $10 a month? Let’s say the account currently has $10,000 and yields 3.5%. This means that the account currently earns $29/month in interest. If the $10 were added to the account, that would be the same as the account earning $39/month. A $39/month gain on $10,000 turns out to be 4.68%. Who among us would say reject the opportunity to increase the return on our savings by 34%? That’s a big difference, but it was made by a small amount of money. Just imagine if $50, or $100 were saved instead of $10. What if you can reduce your grocery bill by $25 each month by using buying less expensive brands? How about slowing the car down to save $30/month in gas? Remember, to the financially minded, money saved is equivalent to money earned. Spending $10 is the same as earning $10 less, and saving $10 is the same as earning $10 more.

So maybe saving $10 a month can be a big deal. It is important that all cash flows be considered in comparable terms. In the example above, we changed a dollar-savings to an effective interest rate increase in order to visualize the impact those $10 could have on a savings account. Now, it is true that the more money you have the more money you need in order to have the same kind of impact as shown above. The true point, however, is that a bit of money that may seem small in comparison to one thing (ie $10 compared to your monthly income), may be large when compared to another thing (like the interest earned on the savings account). Such small steps can give big results, given time. So start now to think like a financier. Even if you do not know how to do the calculations required to make these comparisons, you can still use your judgment to estimate. And when in doubt, find someone who can help.

Posted on 8 Aug 2008