By Isaac Chanakira
Before you begin your investment journey, just like learning a new language, you need to learn enough basic vocabulary to get started, and you can then improve as you get along. It is the same principle that you must apply in finance if you want to be successful in your wealth creation journey, you need to understand the underlying vocabulary used. I am going to try and explain some of the financial terms in a way that you can easily understand. You will probably recognise some of these words because they are mentioned at school during the mathematics lesson.
The below financial terms will help you understand the basics of investing, and as Konrad Bobilak stated in his book, Property Finance Made Simple.
“In life, you will end up either a ‘slave to money or a ‘master of money’, your level of ‘financial education and intelligence’ will determine your category.”
Here are the 14 financial terms that you need to be familiar with:
- Principal-this refers to the total saving amount that you are going to use to start your investment journey. If you have saved $7000 and you have decided to use $5000 of it to invest, that $5000 is the Principal Amount. If you put in the total amount, then the $7000 becomes your Principal Amount.
- Simple Interest- is determined by multiplying the daily interest rate by the principal by the number of days that elapse between payments.
- Example, if you put $5 000.00 at 5% interest for one year, you will get 5/100 multiple by $5000.00 which equals $250.00 (simple interest). At the end of the year, you will get $5250.00 which equates to your principal plus your simple interest.
- Compound Interest- When I talked about the simple interest, I mentioned that at the end of the investment period you would take all your money out of the investment. If you reinvest the money gained from the investment for another year, the interest that you have earned ($250) plus your initial amount invested ($5000) will become your new principal for the second year. Therefore, the interest that you have earned is also going to produce interest in the second year. If you reinvest the money in the investment each year, your investment will continue to grow because of the added advantage of the interest earned.
- You will hear and read about compound interest many times in your investment journey. Some people will make you believe that compound interest is the pinnacle of all investment tactics and for a good reason too. It is crucial to fully understand the power of compound interest because it can make or break your investment aspirations. Compound interest is a double-edged sword. It accelerates your gains if you are an investor, and it also magnifies the losses if you are the borrower. So, you must be on the right side of the compound interest for it to work in your favour.
- Return on Investment (ROI) – is a measure of the gain or loss generated by an investment relative to the amount invested and can be expressed as a percentage. Using our example above, let us assume that you did not know the percentage interest that you were going to get after a year of investing $5 000.00 and you receive $250 as interest gained. You can then calculate your ROI by dividing the $250 by $5 000.00 and multiplying the result by 100 to get your answer in a percentage form. ROI= 250/5000 X 100= 5%. Sometimes calculating the ROI is not as straightforward as mentioned above, it depends on the type of investment that you are considering. When investing in property ROI is referred to as yield.
- Asset- to make it simple, an asset is anything that puts money in your pocket. There are two types of assets, the appreciating assets, and depreciating assets. It is crucial to distinguish which asset is which.
- Depreciation- is the loss in value of fixed assets.
- Appreciation- is the gain in value of fixed assets.
- If we use an investment property as an example, a house is a depreciating asset whereas the land is an appreciating asset. I think it is better to buy an investment property with a bit of yard on it, e.g., free-standing house or townhouse on a block of land than purchasing a unit. You can still build wealth buying units, but, personally, I do not prefer that method.
- Liabilities- are anything that takes money from you. There are two types of liabilities, good liability, and bad liability. If you borrow money to invest, e.g., buying an investment property, that kind of liability is good whereas if you borrow money to throw a huge birthday party, that type of debt can be considered as bad. Please recognise the difference between the two types of liabilities; the good liability has got the potential to boost your wealth whereas the bad liability can derail your chances of becoming financially secure. Do not be afraid to take the good debt, but you must avoid the bad liability at all costs.
- Portfolio – this refers to a range of investments owned by an individual, a trust, partnership, or a company.
- Growth – is the increase in the value of your investments, e.g., let us assume that the house that you bought for $550 000 five years ago is now $750 000. Therefore, the growth is the difference in the purchase price and the current valuation. $750 000-$550 000 = $200 000
- To calculate the growth rate (expressed as a percentage) for the property mentioned above, we divide $200 000 by five (the years that we have been holding the property). The answer is a yearly increase of $40 000, and now we divide $40 000 by $550 000 (the purchase price) and multiply by 100 to get a growth rate 7.27%.
- Yield – is the total amount of returns in a year, e.g., the total amount of rent divided by the original cost of the house and then multiplied by a hundred to get the percentage return. If you pay $550 000 for an investment property and your tenant pays $600 per week you can calculate the yield as follows:
- $600×52 weeks is equal to $31 200 per year. Now divide the $31 200 by the cost of the investment property $550 000 and multiply by 100 to get a yield of 5.67 %. The formula for yield is 🙁 weekly rent x 52) / cost of property x 100
- Equity- is the amount of money that remains in your pocket if you decide to sell the asset and pay off what you owe the bank. Let us assume that the house that you bought for $550 000 five years ago is now $850 000 and you have decided to sell, and you still owe the bank $350 000. If the house sells for the current value of $850 000 and you pay the bank the remaining $350 000, then your equity is $500 000. The $500 000 still includes the associated selling costs such as capital gains tax, discharge fees, etc. For this example, let’s keep it simple and ignore all these other expenses and assume that the money is all yours.
- Leverage- this is when you use borrowed money to invest and enhancing your chances of getting a more significant ROI than you would otherwise get if you only used your money. People commonly refer to leverage as using other people’s money (OPM), and this can be a compelling strategy if used in conjunction with sound investment due diligence. On the flip side, leverage has got the potential to decrease the value of your investment further, and you can end up losing more than you initially invested. It’s like a fire, which is a good servant but an evil master.
- Example 1 no OPM: If you invest $10 000 in BHP shares at $25 per share you will get 400 shares in your portfolio. If the BHP share price rises from $25 per share to $26 per share, your portfolio value will increase by $400 to $10 400. That is ($26-$25) x 400 (number of shares own) plus your initial $10000 = $10 400.
- Example 2 with OPM: Now if you borrow $90 000 from the bank and put your $10 000 on top you can buy BHP shares worth $100 000. You will get 4000 shares in your portfolio. If the BHP share price rises from $25 per share to $26 per share, your portfolio value will increase by $4000, and your equity will be $14000 which consists of the initial $10 000 plus the $4 000 that you get through the leverage by using money from the bank.
- Before you get too excited, let us look at the downside of using leverage. In example 1 with no leverage, you will only lose $400 out of your $10 000 investment if the BHP share drops from $25 to $24 per share but in example 2 with leverage, you will lose $4000 of your initial $10000. So, you should be extremely careful when you decide to use leverage.
- Inflation- Is the fall in the purchasing value of money caused by a general increase in prices. Some years ago, you could buy a house for $75000, but at present $75000 is not enough to put down as a deposit for the same house. The value of $10000 today is much more than it will be in ten years’ time due to inflation. Inflation is the reason why keeping your money under the pillow is not such a bright idea because over time the buying power of your money will continue decreasing.
- Marginal tax rate- the highest tax rate you pay depending on your income. More income will put you in a top tax rate bracket, therefore the more you earn, the more tax you pay. There are ways you can legally reduce the tax you pay.
- Margin Lending- This is when you use part of your funds as security for a more substantial loan from the bank. In short it is the relative amount needed to carry out a leveraged deal.
- For example, if you want to buy shares for a hundred thousand dollars, the bank will require you to pay twenty thousand dollars of your money, and they will pay the remaining eighty thousand, which is equivalent to 20 percent margin lending. Margin lending can help boost your returns, but it can also magnify your losses if the market goes down.
I have kept the calculations as simple as possible, but I assume some will still find them difficult to comprehend. Try to go through the examples repeatedly until you can grasp the concepts or try to seek assistance from anyone who is in high school or has done high school mathematics.
Warren Buffet once stated that; “If calculus or algebra were required to be a great investor, I’d have to go back to delivering newspapers.”
The fact that Warren Buffet is now one of the wealthiest people in the world through investing, gives us hope that we do not have to be mathematicians to become successful investors.
There are many other financial terms that you will come across depending on the investment vehicle or vehicles that you chose to use in your wealth creation journey, and the ones that I have explained are common and are essential to understanding, before investing. As part of your due diligence, you need to consult your financial planner or accountant for help before you commit any of your hard-earned money into any investment.
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