Discover the five basic principles of finance to improve your financial literacy, including the time value of money, risk management, compounding and more.
Learning financial principles is essential to managing personal and business finances, making informed investment decisions, and understanding the economy. Here are five basic principles of finance you need to know.
Time value of money
This principle suggests that a dollar received today is worth more than a dollar received in the future because of the potential to earn interest or investment income. It is the foundation of many financial decisions, including investment strategies and loan repayment plans.
For example, if an investor buys 1 Bitcoin
btc
Ticker below
$25,849
For $10,000 in 2017 and holding until 2021, when the value reaches $50,000, the investor would have made a 400% return on his initial investment. It represents the time value of money because the investor has been able to earn significant returns by holding his investment over time.
Related: What is Time Value of Money (TVM)?
Another example of the time value of money in the cryptocurrency market is the concept of staking. Some cryptocurrencies like Cardano
ADA
Ticker below
$0.357
and ether
ETH
Ticker below
$1,735
, allows users to earn interest by holding their stocks. In exchange for this service, partners receive rewards in the form of other cryptocurrencies. This represents the time value of money, as shareholders can earn a return on their investment over time by holding and using their cryptocurrency.
Diversity
The principle of diversification is to spread your investment portfolio across several assets to reduce risk. This is a way to protect your portfolio from the negative impact of a single investment.
Holding both stocks and cryptocurrencies can help an investor diversify their investment portfolio. By diversifying the investment across different assets with different risks and returns, it can reduce risk.
For example, if the stock market falls, the value of an investor’s shares may decrease, while the value of their cryptocurrency may remain the same or increase. Similarly, if the cryptocurrency market improves, the investor’s equity value will compensate for any loss.
Risk and reward
This principle states that the greater the potential reward of an investment, the greater the risk. Investors should weigh potential rewards against potential risks before making investment decisions.
As mentioned earlier, the potential return of an investment is often tied to its level of risk. Because they are not backed by any government or central authority and their prices are highly volatile, cryptocurrencies are generally considered riskier than stocks. Investors may be willing to take more risk. However, the investor’s risk appetite and investment objectives will affect this.
Distribution of property
This policy involves dividing an investment portfolio across different asset classes, such as stocks, bonds and real estate, to optimize returns while managing risk. Asset allocation is key to creating a well-diversified portfolio that matches an investor’s goals and risk tolerance.
An investor can allocate a certain percentage of his portfolio to stocks and another percentage to cryptocurrencies based on his investment goals and risk tolerance. For example, an investor who is not very risk-averse may allocate a higher percentage to stocks, while an investor with a higher risk-tolerance may allocate a higher percentage to cryptocurrencies.
Mixed
This policy involves reinvesting earnings from an investment to generate higher returns. Over time, compounding can lead to exponential growth in investment returns. It is a powerful tool for building long-term wealth, but it requires patience and consistency.
This principle applies to both stocks and cryptocurrencies. For example, a shareholder of a stock that pays dividends may reinvest those payments to purchase additional shares, thereby generating additional dividends. Likewise, a cryptocurrency owner who earns interest can reinvest that money to earn even more interest. The cumulative effect of compounding will add up over time and contribute to the overall return of the investor.
