Wednesday, April 28, 2010

Understand the Rules First Before Bending Them

I once worked for a manager who took pride in being able to bend the company rules on a regular basis. He didn't ever break a rule, and therefore was not violating company policy. This principle worked well for him while he was based in the home country. When he was transferred internationally, he tried to instill the principle of bending the rules in his new organization. He learned quickly the principle didn't work because his new organization didn't know the rules and thus, didn't know how to properly bend them.

How, one might ask, is this topic related to personal finance? Simply,  there are financial products that "bend" a principle to create what appears to be a better deal. One should understand the principles of basic financial concepts before venturing into more complex financial products. Here are two fundamental financial principles that I believe need to be understood before considering complex products:

  • Compound interest. This concept is the foundation of many financial products, including credit cards, and mortgages. For example, if I didn't understand compound interest, I would choose to use "plain vanilla financial products," such as cash for everyday purchases and a 20% down fixed rate mortgage to buy a house.

    Understanding compound interest has helped me make some good financial decisions  for using credit cards and mortgages. For example, we do use a credit card, but we pay off the entire balance every month. In effect, we get an interest free loan from the credit card company for twenty days. For our mortgage, we avoided products such as ARMs, option ARM and interest only loans, since we planned to live in our house for a while, making a fixed rate mortgage more advantageous.

  • Risk versus reward. For financial products, with higher rewards typically come higher risks. Rarely, does one get something for nothing in financial transactions.  Junk bonds offer higher interest rates because the risk of default is higher.  Leverage can increase returns significantly but also can cause higher losses. Stocks have higher long term returns than bonds but can have higher losses in the short term.

    Understanding the trade off between risk and reward doesn't mean I always take the lower risk option.  It means that I am ready and able to accept the downside if it happens.

  • I am not saying that I would never borrow money on a credit card, take out an adjustable rate mortgage, or make a high risk investment.  However, I would understand the fundamental financial principles before doing so, and be ready to accept a negative outcome if I made an incorrect decision.

    For more on The Practice of Personal Finance, check back every Wednesday for a new segment.

    This is not financial advice. Please consult a professional advisor.

    Copyright © 2010 Achievement Catalyst, LLC

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