In this video I tackle the question “What is Finance?”
What is Finance? This really simple question confuses a lot of people and understandably so. Finance is a really broad subject area and so bottling it down into kind of a definition is difficult. So what I’m going to do in this video is I’m going to provide you a definition for finance and then we’re going to walk through an example that I think illustrates what finance is all about.
So let’s get started with the definition. Finance is the science of managing money. No matter what you’re talking about in finance, it always comes back to this central idea. So if you’re talking about asset allocations, or you’re talking about planning for your retirement, you are always coming back to the same question. What is the scientific approach I am going to take to make that decision on what is the best way to manage my money?
Now you might be saying, if it’s really that simple, why is finance so complicated? Finance gets complicated very fast, and I have an example that illustrates why. Imagine for a moment, you have ten thousand dollars sitting in your bank account, and let’s assume that you don’t need to use this money immediately for expenses. So you don’t need it for rent or food. You just have the money sitting in your savings account. You then need to decide, what is the best way to use this ten thousand dollars. Now you really have unlimited options, but let’s just use five different options for this example. Some things you could do with the money are:
- Home renovation
- Stock market
- Keep in your mattress
So the question becomes, how do you decide between those five options? What is the best way to manage your money? You might be tempted at this point to say, “Each of those options has a certain rate of return, and we should just select the highest return for our money.” It’s not really that simple. Each of these options has a rate of return but they each also have risk associated with them. For example, take education. The way education works is you invest money in training and ideally that is going to translate into more money in the future, whether it’s from raises or a career change. There is a rate of return on that investment, but there is also risk. There is a risk you may not get the job you want, or the raise you want. Here is where it starts to get complicated. Because that element of risk is different for every person. Everyone who looks at this example is going to have a different answer. I could think of a situation where each one of these items would be the correct choice to make, depending on that individuals situation. For instance, the choice to invest in education might make more sense for a younger person than it would for an older person that has a different risk tolerance and time horizon.
So this is how these problems get really complex really quickly. It’s almost like an impossible problem to solve because there are so many different variables. This is just five different options that we are looking at, but really it is an infinite amount of options because you have an infinite way of spending your money. So that’s how finance gets complicated really quickly. So you might ask, “if it’s an impossible question to solve, do financial tools really help?” The amazing thing is they really do. We are going to talk through some of those tools in these videos. You might be saying “What if I don’t have ten thousand dollars? Why should I care?” The answer is that it is not really about how much money you have. It’s about financial decision-making. Your goal is to make the best decision. No matter what you’re evaluating, if you are deciding what type of loan you should take out or what kind of investment you should make, or even bigger decisions like what kind of career you should go after or what cities you should live in. If you can frame your decisions in terms of financial impact, risk, and rate of return, then you’ll get better outcomes. What you’re essentially doing is you are putting your assets and liabilities in places based on what you think is going to have the biggest impact in the future. Using financial tools and processes will lead to better outcomes that are more aligned with your goals.
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Neither Zach De Gregorio or Wolves and Finance Inc. shall be liable for any damages related to information in this video. It is recommended you contact a CPA in your area for business advice.