This blog post simplifies personal finance math, covering key concepts such as absolute return, compounded annual growth rate (CAGR), extended internal rate of return (XIRR), and the time value of money, enabling readers to make informed investment decisions.
Personal finance can often seem daunting, especially when it comes to the math involved. However, the reality is that personal finance math is quite simple and accessible. In this post, we will break down essential concepts that will help you get started on your investment journey.
Many people hesitate to engage with personal finance due to the misconception that it involves complex calculations. In truth, you only need to grasp a few fundamental concepts to begin investing, even if it means starting with a small amount.
The most basic method to calculate the return on an investment is known as the absolute return. To illustrate, let’s consider an example:
This calculation shows that the absolute return on Stock A is 16%. However, absolute return does not take into account the time period of the investment.
Now, let’s consider another investment:
At first glance, Stock B appears to be the better investment based on absolute return. However, this approach is misleading when considering the time factor.
To accurately assess investments over different time periods, we use the Compounded Annual Growth Rate (CAGR). CAGR provides a more accurate picture of growth by considering the time factor.
Let’s return to our investments:
In this case, Stock A is the superior investment, despite Stock B having a higher absolute return. This highlights the importance of considering CAGR when evaluating investments over multiple years.
When dealing with continuous investments, such as making regular contributions, you will need to calculate the Extended Internal Rate of Return (XIRR). This metric is similar to CAGR but accounts for varying investment amounts and timings.
Assume you invest 25,000 at the beginning of each year for three years, totaling 75,000. If you withdraw this amount after three years and it has grown to 90,000, you would use XIRR to calculate your return.
Understanding the time value of money is crucial in personal finance. This concept helps you evaluate options involving money across different timelines.
Consider a scenario where a friend offers you 84,000 today or 100,000 in two years. To determine which option is better, you need to calculate the future value of the 84,000 if invested, and the present value of the 100,000:
In this case, both options are equivalent, demonstrating the importance of understanding the time value of money.
In summary, personal finance math is not as complex as it seems. Here are the key takeaways:
With these concepts in mind, you are now better equipped to understand mutual funds and make informed investment decisions. If you have any questions about the math discussed, feel free to reach out. In the next video, we will delve deeper into mutual funds and the structure of asset management companies.
