Financial Literacy

Basics of Financial Literacy

6 Mins read

Whether one likes it or not and regardless of your Profession/Skill Set, religious and cultural background etc., living in the modern world one is forced to deal with financial matters on a daily basis and make financial decisions regularly. In doing so it helps to understand about Money (a dirty word or source of all evil in some cultures) and how better decisions can be made with regard to money matters regardless of your age or background. In the following listed bullet points and paragraphs I attempt to set out a broad (albeit brief) outline of ABCs of Financial Literacy which is readily useful in such decision making and a framework to think and act on.

  1. Capital Outlay (investment) and Annualized Return
  2. Risk – Assessment or Estimation, Quantification (where possible) and Risk taking/tolerance
  3. Understand the characteristics of an Asset (different asset classes) and a Liability
  4. Debt or Credit – how much, what terms, and how to deploy
  5. Passive (Investments) Income: Capital Gains and Cash Flow – both are important
  6. Time Value of Money and Compounding Effect (I have touched on these in previous notes)
  7. Building a Portfolio and Diversification of Risk as well as Assets/Income

Capital Outlay

Whether you are a businessman, a lay individual, or a Corporate one has a limited amount of funds at the beginning or to start with. How one deploys this limited/precious resource efficiently and effectively will determine how far one goes and how quickly. So focus on annualized returns. By annualizing one gets to compare/evaluate one investment (deployment) with other alternative investments/business opportunities as most investments are evaluated in terms of an annualized return. I have seen many veteran and successful businessmen lose this focus for various reasons and slow down progress/growth.

 I emphasize on and personally favour not being a businessman but being a passive Investor. A passive investor is someone who invests mainly in Assets – Apartments, Land, Forex, Precious Metals/Stones, Art, Crypto or anything else that appreciate (or depreciate) in Value over time. The only time a passive investor invests in a business is as a minority shareholder (no active involvement/control in the business) in a listed Company in a reputed, well regulated (supervised) Stock Exchange (Ex. CSE, NYSE etc.). It is important to also be mindful of liquidity (sellability with ease and without having to discount) of these different Assets when making investment decisions. Ex. Land may have comparatively lower liquidity (relatively difficult to sell/encash) than Stocks which are readily encashable.

Returns comprise of two components. Capital Gains (CG)and Cash Flow (CF). The appreciation of an Asset (Financial or Real) in value over time is CG and the regular or periodic income one gets (Rent, Dividends, Interest etc) is Cash Flow. Some Assets like Land, Art, Precious Metals may not have CF but more often than not the CG compensate for that. Other Assets such as Fixed Deposits will not have CG but CF streams are substantial and comprise 100% of the Returns. It is prudent to build up a Portfolio of Assets (resource/asset allocation) over time with different characteristics in terms of Returns and Risk profiles. (also remember tax treatment of CG and CF are different).

Assets should give you net Cash Inflow (Ex. FD, Apartment). Liabilities create net Cash Outflow (Ex. Debt/Loan or a Vehicle). Land, Art etc are considered Assets even though they give you no Cash Inflow because the eventual CG one makes/realizes at the time of sale of the asset is usually positive. Even before selling the market value minus the cost of investment should indicate the unrealized CG. Annualizing the CG (use the CAGR formula or calculator) will give the investor the annual Return percentage which then can be used to compare say your Land investment with other alternative investments.  (CAGR = Compounded Annual Growth Rate automatically takes the time value into account.)

In SL people often errounousely regard Vehicles as Assets. Never regard a Vehicle which under normal conditions should depreciate, as an Asset. The high maintenance costs/cash outflow alone should be enough to categorize Vehicles as Liabilities.

Risk

There is no investment or business without Risk. There is no sure fire (risk free) investment anywhere in the world (even US Bonds have inflation risk or interest rate/reinvestment rate risk etc) as investments invariably involve/include uncertainities of constantly unfolding time/future and events. Risk is the probability the outcome (Return) expected may not materialize. How one assesses this Risk and make the decision/take the leap to go ahead and invest (level of risk tolerance of each individual) is essential if one expects to reap the benefits of future Returns. Zero risk taking (ie Not investing) can only lead to zero Returns. Fear of failure or losses prevent many people from not taking the risk at all or playing it safe (often keeping their funds in Treasury Bills or FDs in a large, well established Bank). Others manage the fear and take a calculated chance. Financial literacy is all about helping individuals do this calculation and mitigate (not eliminate) the risks.

Loans/Debt/Leverage/Borrowing – Debt is creating a fixed liability or Cash outflow. Again in certain cultures the attitudes towards Debt is negative. There’s nothing negative about Debt/Borrowing. In fact, it is quite useful as long as one is financially literate. Just be aware of the following;

  • Never borrow for Consumption (buying Vehicles, Electronics, Clothing, F&B/Entertaintment etc). Borrow only to invest in Assets that give you a better annualized Return than your cost of borrowing.
  • Know How much to borrow depending on your repayment capacity/Income. Debt has to be repaid regardless of what happens to your investment. Also it would be prudent to have liquid assets which can be sold to repay your Debt (or a part of it) should things not go according to plan.
  • Shop around and if possible negotiate for the best terms – interest rate, flexible or fixed, repayment     Period, collateral amounts etc. (I strongly suggest Permanent Over Draft facilities are a good way to borrow for an investor)

Earlier I mentioned the precious little/limited funds many have to do investments. Those funds can be considered your Equity. If the Equity amount/Investment you have amount is small, the corresponding Returns (in absolute terms) will be small until you build it over time and therefor it will take a bit longer to reach your goals/targets. One way to enhance your returns and get to your goals quicker is by leveraging or taking on Debt to make a bigger investment than other you could have made with your own funds/Equity. However be mindful Debt or Leverage enhances/increases your overall Risks as Debt/Loans must be repaid on time no matter what. So remember higher the leverage higher the Risks.

Time Value of Money is also an important concept and I have discussed that in other similar notes. If more detailed explanations are necessary, internet has many good resources. Basically funds – Equity (your own) or Debt (borrowed) – will grow on a daily even hourly basis. Make sure it is well deployed in terms of growth rate (usually annualized for easy comparison). Funds should never be idle. Not even a day.

Building a balanced Portfolio of Assets

Now the final challenge is to build up a Portfolio of Assets with different characteristics and risk levels so that one has a Portfolio with mitigated risks but good annualized returns. By diversifying across Asset classes (Real and Financial, High CF to no CF/high CG, Rupee Denominated Vs Forex (USD, Euro, Sterling etc) Denominated etc), one can build a well balanced Portfolio and diversify Risk. Pay attention to the percentage of exposure to each asset class within the overall Portfolio. This way even if a certain investment of yours go completely belly up, the negative effect on the Returns is minimized.  Do not over expose to one Asset Class unless your judgement is that Asset Class gives you the best annualized returns for particular level of Risk (admittedly the risk assessment can be somewhat subjective or differ from individual to individual). Depending on the size of the Portfolio and objectives/need etc., 3 to 5 different asset classes in a Portfolio with 20 to 50% exposure to each Asset Class would be a reasonable level of diversification and risk mitigation. Finally, in SL context where the Rupee is constantly under pressure of depreciation, it is vital to hold assets priced and tradable/sellable in a stable, strong foreign currency.

Concluding Remarks

The above is a brief synopsis of the key components one needs to understand and internalize to be reasonably financially literate. All theses topics have enough material on the Net that go in depth into each area if one is interested in further exploration. However, I believe the topics/points listed above in this Note covers all the critical areas and constitute a good starting point. They say good investments or Risks are identified not with your Eyes but with your Mind. One needs financial literacy and a framework to think, reference points to evaluate/assess and act on to train the mind to see the opportunities that present themselves during economic upturns as well as downturns (Cycles). If mastered this should make anyone’s life journey comfortable and secure in financial/material terms. So keep reading, learning and experimenting (ie. Take a limited risk and invest). You will only master/internalize the concepts by overcoming your fears and taking the plunge. Happy investing (hold long term) and trading (short term cycles).

Cover image from thevillagefamily.org

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About author
Masters in Business Administration (MBA) with a concentration in International Business and Economics from University of Texas, Arlington, U.S.A., December 1994 | Bachelor of Science Degree in Business Administration with a major in Management from Hawaii Pacific University, Honolulu, Hawaii, 1991 | Certificate in Modern European Languages (German, French, English) from the Swiss School of Tourism, 1981 | Worked in the senior management at the Secretariat of the Securities and Exchange Commission of Sri Lanka (SEC) from September 2005 to February 2013 mainly as Director Surveillance and as an Equity Portfolio Manager at DFCC Bank and in the Seychelles | Currently retired from full time work but engaged in making Investments and Trading in Real Estate and at the Colombo Stock Exchange. Managing Director at Ethena Home Investments Ltd.. Also engaged in advisory work on Business Feasibility, Capital Restructuring, Investment Management etc.
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