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5 Financial Literacy Fundamentals You Need to Make Informed Decisions Thumbnail

5 Financial Literacy Fundamentals You Need to Make Informed Decisions

Some parents are experts in medicine, or construction, or education. Our expertise is in finance. That’s the subject where we most want to pass on knowledge to our kids, and we believe that financial literacy is crucial to setting children (and adults) on a clear path to success.

That’s because if you and your children have a clear understanding of how money works, how investments work, and any number of other concepts work, you can be your own financial leader. Below, we explore five financial literacy fundamentals that can help you make informed decisions and take charge of your family’s wealth.

You may already be familiar with some of these concepts, but as you review them, you may recognize ways that you can put them to work more frequently in your financial plan.

1. Compound Interest
Here’s how compound interest works: the longer you give your money to build, the more your money actually works for you. Let’s take an example of two people, Mary and Bill, who both decide they want to start putting aside money for retirement. Mary gets a jump on this project early, starting at age twenty-four. She invests $10,000 a year for ten years, putting $100,000 total in her retirement account.

Bill puts his retirement goals off an additional decade, and starts putting aside money at age thirty-four. He also invests $10,000 a year and continues to invest until he retires, ultimately putting in $320,000. Here’s a picture of their two exponential curves, based on their different starting points :

Mary’s curve ended up much higher than Bill’s even though she only put in $100,000 compared to his investment of $320,000. Why would that be?

The answer: time. Mary gave herself an additional ten years to let that interest compound, and it was in those final ten years that her curve shot up at its steepest. It’s a common investing mistake to solely focus on the interest rate or rate of return. In reality, time is the most powerful component in the equation.

2. What It Means to Be Financially Independent
Some people assume that financial independence simply means you have a job and you can pay your bills. However, that’s not true independence. To be financially independent means you have the ability to live off the income and growth of your investments, along with any fixed income sources; you are not reliant on an employer for a paycheck..

We recommend goal-based money management as a way to clearly address your financial needs and work toward financial independence. Goal-based management involves setting aside different “buckets” of money that you need in order to meet your different financial goals.

The first bucket should be “Emergency Allocation,” or the money that you need to be able to survive six to twelve months if there were an emergency.

The second should be “Fixed Gap Allocation,” or the amount of money that you need annually to meet your fixed expenses.

You should also have a bucket for “Discretionary Spending” to cover things like dinners, vacations, etc.

Many people also set up a fourth “Legacy” bucket that represents money above and beyond what they need to live on. With this money, you can pursue amazing aspirations, including setting up a legacy of an inheritance.

3. Human Capital vs. Financial Capital
Human capital and financial capital are key aspects of financial literacy that should be understood. Financial capital is pretty straightforward: it’s the money you possess. Human capital describes a person’s earning potential.

Human capital is the present value of future earnings, and should be thought of as an investable asset. Any effort made to increase future wages could be considered an investment in human capital, and going into debt to get an education is essentially investing in your human capital.

Our youngest son Jack, as a three-year-old, has zero financial capital. However, early in life, human capital is sky-high. As you go through school, gain work experience, and go to college, you are making consistent investments in your human capital.

With each year you work, though, you presumably have one less year of work to give. Your human capital—your earning potential—falls a little more every year. Notice though, that as human capital falls, financial capital grows. That is, it grows if you have saved and invested for the future.

In an ideal world, your financial capital would continue to grow exponentially as you get older. That way, you could live off the interest of your wealth without diving into the principal.

4. Cash Flow
Imagine that you sit down to play a game of Monopoly. The game gets off to a good start; you land on multiple valuable properties and you’re able to put together the cash to buy most of them. Finally, you land on the most valuable property of all: Boardwalk. You already own its neighbor, Park Place, and if you could manage to buy Boardwalk, you’d have a monopoly.

There’s one problem: you’ve already spent all your available cash when you purchased the other properties in your hand. Although you look like the wealthiest player with all your properties, you have no cash flow. If cash flow dries up, even the most impressive financial assets can be lost.

“Cash flow” describes the income generated from your assets on a periodic basis. In Monopoly, for instance, you know that you’re going to collect two hundred dollars every time you pass “Go.” In the real world, if your assets are producing a steady stream of income which is available to you to spend, you have positive cash flow. However, if that money is tied up in inaccessible assets, or delayed, you have poor cash flow.

When you have reliable cash flow, you’re able to take advantage of opportunities. When all your net worth is tied up in inaccessible assets, you risk missing out on some of those opportunities and may likely experience additional stress.

5. Spending Habits
America is not a country that generally encourages financial restraint. If marketers had their way, we would all operate via impulse buys. Most of us get a constant barrage of marketing which makes us want to hurry and buy! Buy and enjoy! Then hurry and buy again! But it’s the long-term vision of financial goals that will ultimately make you and your kids more successful when they spend money.

Here’s why this matters, especially for people who are starting off wealthy: if you spend your money mainly on the experiences of “today”—on the house, the cars, the activities, and so on— yet fail to save for the future, your estate will not last for future generations. Your children will have no idea how to operate with long-term goals or future generations in mind, and the money will evaporate. For people with more modest means, failure to consider the future could even make you a burden to your children later on.

Given the complicated considerations that need to be weighed with most financial decisions, there’s no one formula which will help you determine the right spending decision every time.

However, by developing the fundamentals we’ve already highlighted, you’ll be better equipped to thrive in many areas of life and certainly in the area of wise spending.

Financial Smarts Form Your Strategy
With great wealth comes a greater need for depth of knowledge, and once you've developed fundamental skills, you’ll have the confidence to move on and enhance them. Financial literacy works the same way. Competence breeds confidence.

Because of how directly each piece of financial literacy knowledge informs strategy, an understanding of these concepts will directly impact your ability (and your children’s ability) to pass wealth on. The more financial smarts you have, the more capable you will be in forming a strategy for building and maintaining your wealth.

For more advice on financial literacy, you can find Pass It On on Amazon.

Roger and Lori Gervais are proud parents of three wonderful children: Anna, Will, and Jack. Roger and Lori are also the husband-and-wife team behind The Gervais Group, named by Forbes as “Best in State Wealth Advisors” in Wisconsin. Lori, a CERTIFIED FINANCIAL PLANNER™ professional, has been recognized for her commitment to clients and to the profession by Forbes, which named her to its America’s Top Women Advisor List. Roger, a CFA® charterholder, uses his background in engineering to offer clients a unique set of problem-solving skills. Throughout their thirty years of combined experience in the industry, Roger and Lori have made it their mission to simplify the complex world of financial planning.