What are some basic financial principles that people often don't understand? originally appeared on Quora - the knowledge sharing network where compelling questions are answered by people with unique insights.
Answer by Arshad Ahmad, Assoc. Vice-President & Professor, Finance & Bus. Economics at McMaster University, Instructor of Finance for Everyone, on Quora:
Rather than naming some specific details that have their place in the realm of finance, we need to start with the big picture view in order to consider this question. When it comes to financial principles, everything is connected. Personal finance cannot be learned in a vacuum. The same is true of corporate finance and not-for-profit finance. Finance intersects with economics and politics, psychology, and sociology--it is not just the study of numbers. Indeed, this is one of the biggest challenges to understanding financial principles, one of the reasons why financial illiteracy is so common, and one of the reasons many of us can feel so lost when thinking about money! It's a wonder anyone has the ability to understand the ways money moves. And yet, there are people who do. It can be done. So where do we start?
Here's a simple, yet possibly counterintuitive, idea for understanding the financial principles that are most elusive: make your own plan to achieve financial literacy by starting with ideas or issues that matter most to you. Remember: finance cannot be understood without considering economics, politics, psychology, and sociology. So begin by deciding what topic(s) and current events interest you the most, and use this to drive how you begin to engage with finance. As you continue to pursue topics of interest, you will inevitably begin to learn about the others, and increase your understanding of finance overall.
The McGraw Hill Global Financial Literacy Survey points to the global average that 2 out of 3 people are financially illiterate and that there is a huge variance of financial illiteracy within regions, between genders, and around other demographic factors. As such, anything you learn is a step up relative to the vast majority of your fellow humans, so learn what you can, advance your own learning piece by piece, and understand that any improvements you make will move you considerably closer to the world's financial elite. Again, rather than focusing on detailed financial principles in order to increase your understanding, pay attention to big picture ideas, focus on what's happening around you and in the world, and that will help enhance your hold on finance!
But, okay, I'm sure many of you want more of a concrete example of a financial principle that could be more widely understood. So here's one, and I'll use this example to demonstrate what I mean above. One of the fundamental pillars of finance is the Time Value of Money, which describes how values change over time through the processes of compounding and discounting. This process, however, assumes that interest rates are positive. Now, interest rates are determined by central bankers who are usually trained economists (not financial professionals) and are political appointees. Moreover, the criteria they use are based on broader considerations around current socio-political trends and imperatives, like the unemployment rate or the government's tax policy. So just with this singular, seemingly numerically-based concept, we begin to see the interconnectedness of things in the financial world. And so, while getting acquainted with the Time Value of Money may be important, considering the many factors that affect it and all other aspects of finance can be a relevant place to start developing a basic understanding.
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