Understanding a core group of financial concepts can make the difference between retiring comfortably and never being able to retire. Most high schools and colleges don’t teach financial literacy, and as a result, many of us have to learn the hard way to manage our money. The good news is you don’t need a degree in finance to get the most out of your employer-provided 401(k) retirement plan.
Basic Financial Concepts
Five financial concepts that will help you make the best decisions for your money. These concepts are:
- Return on Investment (ROI)
- Opportunity Cost
- Compound Interest
All of these concepts are related to each other. The better you understand each of them, the easier it will be to make sound financial decisions.
Return on Investment
Return on investment (ROI) is the most important number for your financial health. This tells you how much money you are making from an investment. The most financially successful people work hard to maximize their ROI. Your 401(k) will give you a better ROI than putting your money in a savings account. However, as your income grows, you may find other investments that offer an even better ROI. You are in charge of your money and your retirement savings. You can use ROI to make sure your money is working as hard as you are.
Opportunity cost is a concept that means for every decision you commit to, you are foregoing other options. You cannot have five dollars and use it to buy a latte and also use that same five dollars to buy lunch. With your retirement account, if you don’t maximize your contribution, there is an opportunity cost. You may be missing out on the benefits of additional compounding, or you may be shorting yourself on employer-match contributions. If you have a better way to invest that money, you may not mind the opportunity cost. But, if you aren’t thinking about opportunity costs, chances are you aren’t making the best financial decisions.
Compound interest can either be your best friend or your worst enemy. When you carry significant credit card balances, compound interest is working against you. Every month it costs you more money just to have borrowed that money. However, when you invest money in your employer-provided 401(k), you are making more money over time just for having the foresight to have invested it in the first place.
Do you know what one of the biggest threats to your retirement savings is? It’s the fees you pay. Fees may seem like spare change compared to your account balance. But, the difference of just one or two percentage points in the fees you pay on your investment accounts can mean the loss of tens of thousands of dollars over time. There is an opportunity cost to paying fees, and that opportunity cost is that you have less money to take advantage of compound interest. Understanding the fee structure should be part of the research you do for every investment decision.
What does your retirement savings look like? Is everything in your 401(k)? What happens to your investments if there is a recession? Blindly saving money and hoping everything turns out okay is not an investment strategy. You need to understand the risks you are taking. All investments carry some risk. You can use diversification to protect yourself against some risks. As your income and investment income grow, you want to invest in a variety of different asset classes with varying levels of risk.
The better you understand diversification, the more secure your retirement investments will be.