Thursday, September 27, 2012

7 Pillars of Financial Literacy, Explained (Part 2)

In Part 1, I delved deeper into the first four "pillars" of financial literacy. In this post, we'll take a look at the remaining three pillars and see how they fit the "bigger picture."

5. Managing debt

A lot of people think that "debt is bad," but it isn't--at least not necessarily. Debt is an essential feature of the economy and society-at-large because it serves as a bridge between those who have excess funds and those who need funds. If people and institutions can't lend to or borrow from each other, then excess capital will remain idle and unproductive, economic opportunities will be unexploited, and personal needs unmet.

Debt is "bad" only if: 1) a substantial portion of the borrower's earnings go to interest and principal repayments; and/or 2) the borrower cannot afford to significantly reduce the principal balance of the debt in the foreseeable future. When one or both of these situations arise, the borrower is left with limited spending power for a considerable amount of time, or even indefinitely.

There are several ways of avoiding this "debt trap." First, remember that borrowing only makes sense for certain purchases or situations: a house, a vehicle, and some consumer durables (such as a personal computer, some appliances) if you can justify the purchase and if you can afford the payments; and emergencies. Borrowing for investments is okay only if you can earn returns that sufficiently cover interest, after considering the riskiness of the investment. Needless to say, it's a bad idea to borrow for things that you don't really need, or things that don't "last" (e.g., weddings, trips, parties). Second, if you're going to borrow, look for the lowest interest rates that you can get (for which you need to understand how concepts like add-on interest and simple vs. compound interest work) and avoid very high interest rates, such as what you get if you don't pay your credit card bill in full every month (more than 50% per year effective interest) or if you borrow from loan sharks (anywhere from 5% to 20% add on interest per month). Finally, if you're going to borrow, apart from the interest rate, ask for a quotation of required monthly payments and make sure that these are sufficiently covered by your income less essential expenses.

6. Investing

Once your "expensive" debt has been paid off and you're amply protected by insurance and cash (see Pillar #4 in Part 1), you can start setting aside capital for investment. Investing involves spending money now for the possibility of receiving more money in the future (which is what sets it apart from "saving," where you just get the same nominal amount in the future). Please note that I said that there's only a possibility of earning from an investment--"returns" are never certain, no matter what anyone says. In fact, for a lot of investment instruments there's also a chance that you'll lose a portion of your investment. The possibility that you'll earn less than what you expect or even lose some amount is called investment risk.

Investments may be broadly classified as "passive" or "active." Passive investments mostly just require capital, in exchange for periodic income (such as dividends or interest) and/or capital appreciation. Some examples of passive investments include financial instruments (stocks, bonds, mutual funds, UITFs), real estate, and speculative instruments like currencies and precious metals. Active investments such as business ventures require time as well as capital from the investor; as one of the founders of the business, the investor needs to spend some time in planning, forming, and establishing the venture, and often also in running/managing the business. Entrepreneurial ventures are covered in greater detail in the next item.

In evaluating investments, an investor needs to consider several factors which we label here as "SHORE": Scrutiny – Do you understand the mechanics of the investment? Are the company and business model sound?; Horizon – Can you afford the lockup period of the investment?; Objective – Does the investment fit your financial goal?; Risk – Are you aware of and can afford to take the risks involved?; Experience – Can you take advantage of any existing experience with this type of investment?

7. Starting and running a business

Starting a business does not just go from a great idea straight to the SEC for business registration. Some questions need to be asked first: What's your business model? How will your business make money?; Who are your customers?; What are the risks involved?; What's your exit strategy?; Are the expected profits worth the capital required and risks involved? Once you have figured out the (best effort) answers to these questions, you organize your ideas into a "business plan."

The next step is to figure out how to finance the venture. Can you cover the required capital on your own, or do you look for partners? Is it a good idea to borrow? If yes, from whom?

Finally, being an entrepreneur involves not just shelling out investment capital, but also making important business decisions. For this, a certain degree of understanding of business processes and activities is necessary. The entrepreneur must try to familiarize his or her self with the following "functional areas" of business: Finance - raising capital for projects; Accounting - keeping track of the business's finances; Operations - managing production and/or processes; Marketing - selling the firm's products/services; and Strategy -  making long-term business decisions.

There you have it: the Seven Pillars of Financial Literacy. I hope you'll find these past three posts helpful in charting your way through the deep and wide, sometimes muddy but always enlightening, realm of financial literacy. As always, comments and feedback are most welcome. Enjoy the rest of the week and have a great weekend!

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