Five Key Concepts in Personal Finance

Simple but Extremely Powerful

I got into personal finance a few years ago after reading Your Money or Your Life. Since then, I've been lucky enough to come across a small number of key concepts and think about them enough to internalize them.

If you understand these five ideas you are probably way ahead of most of the population.

1. Compound interest over time

This one is huge. The basic idea is that if you earn interest on something, then reinvest the interest into your investment, the next time round you will earn interest on the original amount and interest on the interest. Over time this can become quite significant.

One important number is the rule of 72, which says that an easy way to work out how long it will take for something to double if interest is compounded is to divide 72 by the annual interest rate.

Stocks' long-term return is above 7% so your investment would double every ten years if you get that return.

What this means is that after ten years you would have x2, after twenty years x4, after thirty years x8, after forty years x16, and so on.

The key concept: the longer you can leave your investments to compound the more impressive the returns.

2. Diversification

This has been called 'the only free lunch in investing' as it can allow you to reduce the risk and volatility of your investments without reducing returns.

The idea is that if you have a range of different investments, hopefully ones that are not correlated (they don't react in the same way) then on average your investments will be safer.

One way to think about this is to imagine an undiversified portfolio with just one company stock in it. If the company lost profitability or went out of business, you could lose everything. Adding more stocks and different types of investments (property, bonds, peer-to-peer lending) would reduce this risk.

The key concept: the more diversity you have in your portfolio, the less likely it is to be seriously affected by a single event.

3. Costs

This one is extremely misleading, because cost in personal finance is quite different to other costs in our life. In most areas cost is linked to quality: if you pay more, you tend to get a better product or experience.

In personal finance, this tends not to be true. If you pay more, you just don't get as much money. As John Bogle says, "you get what you don't pay for".

The key concept: keep your costs as low as possible, because even a small increase in fees has a large effect compounded over time.

4. The power of habit

​This is less about personal finance, and more about discipline or behavior.

Habits are extremely powerful. I imagine most of us brush our teeth every day. Do we have to think about it or make ourselves do it? No, because it's a habit.

In the same way we can create financial habits, like tracking our spending each month (I use Moneytree which makes it extremely easy), saving a set amount on payday into a separate account, investing regularly, or deferring purchases for a week so we can check if we really wanted them.

The key to starting a new habit is to start small (you might try and save 1,000 yen a month into a separate account), do it regularly and consistently (save every month), and set a trigger (you might transfer the money on payday).

The key concept: habits allow you to automate behavior so that you can do things without relying on willpower.

​5. Changing your reality

Similar to number 4 above, this isn't really about money. The way you think about things shapes your perception of the world. You are, in a way, creating your own reality in the way your brain interprets the stimuli it receives from the world around it.

Changing the way you think about money, spending, value, prices, and everyday life is an incredibly powerful way to change your financial habits.

One vivid example for me was when I read something Warren Buffet said about opportunity cost (the concept that buying something means that you lose the ability to buy something else with that money).

Basically he said you should compare the cost of things to what you could do with the money if you invested it.

That gave me two metrics to compare prices to that I didn't have before.

One is to multiply the price of everything by ten, as that is how much I would be giving up by not investing the money (compounded over several decades).

The other is to divide it by 300, and that gives the monthly income the money could earn if it were invested (if it returned 4%).

(there is another metric that comes from Your Money or Your Life, which is to work out how many hours you would have to work to afford the price -this can also be very effective)

The key concept: changing how you think about things can transform your reality.

​How about you? Do you have any key concepts that have helped you think about money?

This post first ran on RetireJapan in February 2016