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5 basic principles of finance you should know

03/10/2023
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Learning the principles of finance is essential for managing personal and business finances, making informed investment decisions and understanding the economy. Here are five basic principles of finance that you should know.

Time value of money

This principle suggests that a dollar received today is worth more than a dollar received in the future due to the potential to earn interest or investment returns. It is the foundation of many financial decisions, including investment strategies and loan repayment plans.

For example, if an investor bought 1 Bitcoin (BTC) for $10,000 in 2017 and held onto it until 2021, when its value reached $50,000, the investor would have earned a return of 400% on their initial investment. This demonstrates the time value of money, as the investor was able to earn a significant return by holding onto their investment over time.

Related: What is the time value of money (TVM)?

Another example of time value of money in the cryptocurrency market is the concept of staking. Some cryptocurrencies, such as Cardano (ADA) and Ether (ETH), allow users to earn interest on their holdings by staking them. In return for this service, stakers earn rewards in the form of more cryptocurrency. This demonstrates the time value of money, as stakers are able to earn a return on their investment over time by holding and using their cryptocurrency.

Diversification

The principle of diversification means to spread your investment portfolio across multiple assets to reduce risk. It is a way to protect your portfolio from the negative impact of any one investment.

Holding both stocks and cryptocurrencies may help an investor diversify their investment portfolio. By distributing the investment among a variety of assets with various risks and returns, this can reduce risk.

For instance, if the stock market declines, the value of the investor’s stocks may go down, while the value of their cryptocurrency may remain the same or even rise. Similar to this, if there is a correction in the cryptocurrency market, the value of the investor’s equities may make up for any losses.

Risk vs. reward

This principle states that the higher the potential reward of an investment, the higher the risk involved. Investors need to weigh the potential rewards against the potential risks before making investment decisions.

As noted earlier, an investment’s potential benefit is often connected with its risk level. Since they are not backed by any government or central authority and because their prices can be extremely volatile, cryptocurrencies are typically seen as being riskier than equities. Investors might be willing to take on more risk as a result in exchange for the possibility of better profits. The investor’s risk appetite and investing objectives will, however, affect this.

Asset allocation

This principle involves dividing an investment portfolio among different asset classes, such as stocks, bonds and real estate, to optimize returns while managing risk. Asset allocation is critical in creating a well-diversified portfolio that aligns with the investor’s goals and risk tolerance.

An investor might choose to allocate a certain percentage of their portfolio to stocks and another percentage to cryptocurrencies based on their investment goals and risk tolerance. For example, an investor who is more risk-averse may allocate a higher percentage to stocks, while an investor who is more risk-tolerant may allocate a higher percentage to cryptocurrencies.

Compounding

This principle involves reinvesting earnings from an investment to generate more earnings. 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 instance, a shareholder of a stock that pays dividends may reinvest those payments to purchase further shares, which will result in the creation of additional dividends. Similarly, a cryptocurrency owner who receives interest can reinvest that money to earn even more interest. Compounding’s cumulative impact can grow over time and contribute to an investor’s overall return.