During my first finance class in college, my professor drilled two principles into my head.
1. The greater the risk the greater the expected return.
2. A dollar today is worth more than a dollar tomorrow.
These two principles can be used when making all of your personal finance decisions, and here’s how.
The first principle, the greater the risk the greater the expected return, will apply to your investing strategy, and also demonstrates why your credit score is so important. But what makes one investment riskier than another?
There are several key factors to consider when looking at an investment’s risk level. One is the length of the investment. For example, if you invest in something like a Treasury Note that will repay you in a year or so, you can reasonably assume a couple of things. One, that the economic conditions should not change dramatically over that time period. And two, that interest rates will remain close to what they currently are. Based on these assumptions, you can conclude that you will receive your original investment plus your return on investment in a year. Since the investment time period is short, the future is better known, meaning there is less potential risk that the market will fluctuate and change the amount of your return or result in a loss. On the contrary, let’s say you invest in a 30 year Treasury Bond. There is no telling what the market will be like in 30 years, so there is a higher risk associated with investing your money in the 30 year treasury bond. Therefore, you will require a premium to be added to your rate of return above what the rate of return is for a Treasury Note.
A second factor in an investment’s risk level is the likelihood of default, or how likely the institution you invest in will be able to pay you back. Rihanna understands this principle well. Bitch better have my money! In general, US Treasury Bonds are low risk. This is because the likelihood of the US government falling apart and the US dollar being worthless are pretty slim. It doesn’t always seem like it in today’s political climate, but its true. In contrast, government bonds from a country experiencing a lot of turmoil, like Venezuela, would be high risk. There is a higher likelihood that their government could fall apart and their currency could diminish in value. So, a person investing in Venezuelan bonds would require a greater return than a person investing in US bonds.
Stocks are another investment type, and are considered riskier than bonds. This is because companies are subject to all sorts of market factors that the government isn’t. Let’s use Lexmark, a printer making company, as an example. In the 1990s when Lexmark became a publicly traded company, it probably looked like a solid company to invest in. People printed everything. Many people didn’t have home computers yet, so they didn’t have personal emails where they could receive documents, smartphones didn’t exist, and computer memory was waaaayyy smaller than it is now. But with the memory storage increases, the development of the cloud, the spread of personal computers and smartphones, printing has been declining rapidly. You even see companies now working to become completely paperless. Still think Lexmark would be a good investment in today’s world? Probably not. This is what makes stocks riskier than bonds. The likelihood that there will be unexpected changes in business is inevitable, and you’re betting on a company’s ability to ride out those bumps. Since stocks are riskier, the return you should expect to get on them is higher than bonds.
And here is how your credit score works into this. The lower your credit score, the riskier YOU are to a bank! A lower credit score tells a bank that if you take out a loan with them, you may not be able to pay them back. And banks are in the business of making money, so they charge you a higher interest rate because you are riskier to loan to. See my post on how lower interest rates can save you lots of money.
Ok, principle two! A dollar today is worth more than a dollar tomorrow. Essentially, the definition of inflation. This is a really important concept when you look at your savings. It is EXTREMELY important to have a savings built up, but most people will lose money in their savings account over time. I don’t mean lose money in the sense that the balance will go down. If you have $1,000 in your savings account now, you will still have $1,000 in your savings account in 10 years. But here is the kicker. You will be able to buy less with the $1,000 you have in 10 years than you can today because of inflation. (Disclaimer: I am not advocating that you spend the $1,000 now!)
Here is how it works. Year 1 is the year when you open your savings account and deposit $1,000. Let’s assume that over the next 10 years the inflation rate will be 2% every year.
| Year | Savings Balance | Purchasing Power |
| 1 | $1,000 | $1,000 |
| 2 | $1,000 | $980 |
| 3 | $1,000 | $960.40 |
| 5 | $1,000 | $922.37 |
| 10 | $1,000 | $833.74 |
As you can see in the chart above, in year 10 the money in your bank account is still $1,000, but it has less purchasing power than when you put it in. So what happened? Each year the inflation rate was 2%, so prices rose by 2%. If you tried to buy something that cost $1,000 in year 1 you could have done it, but in year 2 you would have needed 2% more money, or $1,020 to buy the exact same item. So your $1,000 had less value, or purchasing power in year 2.
Fear not! There is a way to combat at least some of the effects of inflation on your savings. A great option is to open a high interest savings account. These offer much higher rates of return than your typical savings accounts. The average annual inflation rate is projected to be 1.9%, and these accounts currently offer rates that are slightly under that. By utilizing a high interest savings account, most of your risk of inflation is mitigated.
And there you have it! The two golden rules of finance!
1. The greater the risk the greater the expected return.
2. A dollar today is worth more than a dollar tomorrow.
