Episode 2 from the Financial Freedom Series By Maralu Vega - financial educator, business planner, tax coach and investor.
In our previous article, we learned that we will probably have a long life and that we, as individuals, have the power to decide to keep a positive cashflow in our lives through engaging in the habit of saving and investing. If our goal is to eventually reach financial independence (FI) and enjoy a work-optional lifestyle, we need to increase our financial literacy. Our last publication, delivered Insights #1- #3 (click here to review), in this article, we will get a deeper understanding of the “money game” that will definitely play an important role in achieving financial freedom.
Insight #4: Money, money, money…. What is money anyway?
We define money as a token of exchange, a socially convenient way of measuring value while exchanging goods or services with respect to other goods or services. We could get really fancy here and start talking about coins, bills, checks, credit cards, cryptocurrency, and the money registered in accounting books. However, for the purpose of this article, we will keep it simple and understand it to be a standard unit that simplifies everyone's life as it is easily measurable, accountable and comparable.
You get paid for your work and you use money to buy goods/services from someone else to satisfy your needs and wants. Money is the principal component of wealth, but definitely not the only one, and your wealth accumulation ability and your financial success strategy will be directly proportional to the way you view money. What is YOUR view of Money? (Look out for our next delivery).
Insight #5: The Magic of Compounding Interest
Albert Einstein once said, “Compound interest is the eighth wonder of the world. He who understands it, earns it; he who doesn't, pays it”. Well, in reality, it has been questioned if he actually said this, but the ”magical powers” of compounding interest are undeniable.
Understanding this concept will increase your financial knowledge, improve your money management skills and improve your personal finances. For those who love mathematics, there is a formula for compounding interest (please see below). For those who hate math, compounding interest means earning interest on an amount that starts with your initial investment and behaves like a snowball. Your initial investment (snowball) starts earning interest every period and making that snowball bigger, making you more and more money every time. This repeats for as long as you keep the money invested.
Therefore, the longer you invest, the more compounding opportunity, and the more money that you will have. “Time is Money”, remember when your parents used to say this? It now makes sense, right? The reality is that your time is finite and every day that passes by is one less day you have to grow your money.
For all the mathematicians out there: R = P (1 + [ I / n ]) ^ ny; where:
R: Your Return (final amount)
P: Your original Investment - the Principal
n: Number of compounding periods-how often your interest gets deposited in your account (i.e. 12=monthly & 52=weekly)
y: Number of years your money compounds
The longer you invest your money for, more compounding magic will happen. The younger you start, the faster you will reach your Financial Independence Number (FIN). Compounding interest can be compared to planting seeds, with time you will see the tree grow.
Let me show you the magic: If you invest $300 a month, at an average annual interest rate of 8% for 30 years, you will end up with $447,108, all while actually putting up only $108,000 out of your own pocket ($300*12*30). You will have more than quadrupled your money (4.13 times to be exact!!). Since we control our positive cashflow and we have increased our financial knowledge, we could decide to double that amount and invest $600 a month, with the same conditions after 30 years you will end up with $894,216 while only using $216,000 of your own money, (4.13x).
Ohhh! If only I had 30 years to invest, but wait-you probably do. The younger you are, the higher your possibilities of benefiting from the magic of compounding interest, even if you start small… think about it! If you are curious about this calculation go online to https://www.fncalculator.com/financialcalculator?type=tvmCalculatorInsight
#6: The Money Killers - Inflation & Taxes
Achieving wealth is not always a bed of roses, there are two variables that are constantly eating away your investment’s growth: inflation and taxes.
Economists have disagreed about the real definition of inflation, in practical terms we perceive inflation as a diminished ability of our purchasing power, we can now buy less with the same amount of money. The risk of investing or saving (in this context), for that matter is, the purchasing ability that your money will lose over time ($100 today will not buy the same as $100 in 30 years). So, when investing, we need to make sure that our annual return is higher than the inflation rate for the same period.
The next money killer is taxes. We have less autonomy with taxes, as that is the law. Taxes are the Government’s way of financing all the services you get in return: education, roads, transportation, health services, etc. However, The Government also gives us tax breaks that, when correctly used, allow us to become efficient at maximizing our tax returns every year.
BTW! Tax season will start in February 2024, make sure you gather your information by the end of January, don’t let those tax breaks slip your bank accounts. Reach out through maraluvega.com or maraluvega.business@gmail.com for a free assessment.
Insight #7: The Wealth Formula
According to the Oxford Languages dictionary, wealth is an abundance of valuable possessions or money. However, in the eternal pursuit of financial independence and financial freedom, wealth is understood as money working for you, so you can achieve the work-optional lifestyle. In order to achieve that we must attain the right combination:
You can control the amount of money you invest and how early you start investing to maximize compounding interest and, with financial literacy and a good financial advisor, you can understand how to minimize the market volatility of your returns.
There are a few instruments available to grow your money, each with different returns and risks: (1) Savings Accounts in banks or any other financial institution, (2) Guaranteed Investment Certificates (GIC’s) (3) Investing in Stock (whether it is your own entrepreneur company, real estate, or somebody else’s like Apple, Google, etc.) (4) Mutual Funds (Investment Portfolios) and (5) Segregated Funds (guaranteed mutual funds).
Don’t let these terms scare you, these will be the focus of our next article, understanding risks and maximizing your investment opportunities. Before we move forward with investing, let’s review what we have learned and why you are now better prepared to make informed financial decisions.
Summary
Money is just a way of keeping count and a socially accepted trading token, however, you need money to cover your basic needs and eventually to achieve wealth accumulation.
The most efficient way of maximizing your money is through the power of compounding interest, finding the highest possible interest rate that our risk profiles will tolerate is the trick. Remember not everything that glitters is gold!
Wealth accumulation is part science and part art, but learning the basics and starting early can help you achieve wealth by keeping the components of the formula in perfect balance, (+)money (+/-)interest return (-) inflation & (+/-) taxes.
In our next article we will attempt to change your view about money… and to increase your understanding of the 5 ways to grow your money.
(3) AIER - American Institute of economic research. What the Hell is Inflation Anyway? By Michael J. Douma – January 25, 2022.
Comments