You’ve heard a lot about it. You may have flipped past MSNBC and saw the green and red arrows and the acronyms and wondered “What does it mean?” and “Why do people care so much?” Before we go into what those arrows mean and why the talking heads on those networks continue to blab on let’s strip away all the opinion and discuss the facts concerning stocks. (You’ll notice I am not going to discuss much of the mechanics of how stocks are traded that is the subject of the next lesson).
“Don’t put all your eggs in one basket”
-An interpretation of a line in Don Quixote
So we know that given a return we don’t want to take on any more risk unless we have the possibility of more gain. Great! How do we minimize the risk we already have? As the cliché phrase above hints at one way commonly used to manage risk is the practice of diversification. Let’s start by defining it.
- Diversification is an essential aspect of any investment strategy
- Diversification decreases risk of a portfolio by decreasing volatility of the entire portfolio
- Diversification is useful up to a point, but exhibits diminishing marginal returns
It has been in my learning experience that there is no one definition of the word risk. There are many variations on the concept and many ways to view it.
Risk in my opinion could best be described as “uncertainty of results due to the inherent unpredictable nature of the future”. To put risk differently if you had psychic powers and could accurately see what the future held you would have no risk in your life as there would be no uncertainty to outcomes.
- Risk is the chance that your expectations concerning a return are not what actually occurs
- There is a fundamental relationship between risk and return of an investment
Let’s begin with a pretty basic idea and define what an investment is. You have probably heard “John bought Apple stock years ago that turned out to be a great investment” or “by earning a college degree I am investing in myself.”
An investment in its simplest terms is a purchasing of an asset in with relative certainty that the asset you purchase will generate income and/or increase in value. Another way of looking at an investment is that you are sacrificing immediate consumption in hopes of a greater payoff at some point in the future. Let’s go through some examples to paint a clearer picture.
- An investment is an asset that will either increase in value and/or generate income.
- Returns are how we measure how “good” or “bad” an investment is.
I know what you are thinking. Colby…why are you starting these personal finance lessons with such a boring topic? This is a valid point but my rebuttal is simple: without this lesson you will not understand the rationale behind 99% of all financial decisions so I ask you to bear with me and promise we will get to more interesting things.
- A dollar today is worth more than a dollar tomorrow
- A future amount of money has to be discounted to the present
- A present amount of money can be grown in the future
Why is time equal to money? I will answer this question with another wonderful cliché. Time is money because “a dollar today is worth more than a dollar tomorrow.” Why is this?
Imagine I being the benevolent man I am make you an offer. I will either A. Give you $100 today or B. Give you $100 next week. Which should you choose? If you feel inclined to say “the $100 today” you are absolutely correct.
That answer begs the question: why is that the better deal? It is a better deal because that cash in hand has earning capacity. Put differently with that cash in hand you could lend it out charging a certain percentage to the borrower (an interest rate) and grow the money you previously had to a larger sum. YAY more money!
This concept may seem simple but it serves as a foundation for nearly every financial decision made.
Present Value and Future Value
So let’s introduce some really fancy words that are actually quite simple to understand. If you choose to take the $100 today that money represents your present value. As the word sounds the present value is the worth of some amount of money received in the future today. On the flip side of present value is future value. As you may guess future value represents the value of some amount of money in the future based on the value today.
Now there are equations that accompany the present value and future value, but I think the intuition behind the ideas is more important at this point than the equations themselves.
- Interest Rate: The cost of borrowing an amount of money. It is usually expressed as a percentage of the money borrowed (Ex. A 5% monthly interest rate on $100 would result in a payment of $5 per month)
- Present Value: The current worth of a future sum of money.
- Future Value: The worth of an asset or cash at some point in the future
- Asset: A resource with economic value (ex. Cash, land, house, etc.) Another way to think of an asset is something you own.