We continue our life-long learning series and this week, our focus is on arithmetic, as it pertains to your personal finances and money. The summary is below.
We’re going to take a little different approach today than we have with the last two shows. We’re going to talk about two specific things we need to know when it comes to arithmetic, and particularly how math intersects with our money in terms of being important or being useful.
These two things both involve our personal finances. That’s why they’re so important.
Let’s go to The Professor’s Whiteboard fo2 the 2 things you need to understand about money…
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1) The Power of Compounding Money
This can be a little complex so we’ll offer an example that’s so simple we won’t even need a calculator!
2 + 2 + 2 = 6. 2 x 2 x 2 = 8.
If we add two together three times, we get six. If we multiply two by itself three times, we get eight.
That’s the power of multiplication. And money multiplies if you manage it properly.
Stuffing it in your mattress
That’s just numbers. Let’s apply it to money to make it more tangible.
Let’s say you have $2. You stuff it in your mattress. Next year, you get another $2 and put it in the same mattress. The year after that, you do the same. Now you have $6 in your mattress.
But you haven’t earned any money on your money.
Let’s assume that you could double your money every year. Now understand that we’re just doing this for the purpose of illustration.
We don’t know of anything you can invest in and double your money every year. If there was such an investment, it would likely involve taking a whole lot of risk.
So you start with the same $2 that you did before. Only now you invest it and earn 100% on your money each year. Instead of $6, you would end up with $8.
And you only invested $2 one time!
If you invested all $6 at the times suggested above, you would have $14 at the end of the period.
That’s the power of compounding interest. It’s how interest works for you.
But it’s a two-edged sword. It can also work against you. We’ll talk about that more in just a minute.
2) The Basic Accounting Equation
The second thing to understand about arithmetic is the basic accounting equation:
Assets – Liabilities = Net Worth
Of course, our goal is to increase our Net Worth. If we understand this basic equation, we can quickly see there are only two ways to do that.
We increase Assets faster than Liabilities
We decrease Liabilities faster than our Assets are decreasing
Let’s look at the extremes to keep it simple:
- If we increase our Assets without increasing our Liabilities, our Net Worth increases.
- If we decrease our Liabilities without decreasing our Assets, our Net Worth increases.
A painful vacation
Let’s look at a real-world application: What if you borrow money to go on a vacation?
You don’t increase Assets at all but your Liabilities increase. So your Net Worth goes down. You lose financially. You may reap psychic returns but that’s a different post!
It’s the pain we talked about earlier. You have to pay for the vacation over time. You also have to pay interest on the money you borrowed. This is a situation where compounding works against you.
Find ways to increase Assets without taking on more Liabilities or invest in Assets that earn a return higher than the cost of your debt.
Money multiplies if you manage it right. That’s a path to BIGG success!
We’ve talked about the 3 R’s we learned in school. Please join us next time when we begin talking about the 3 R’s of BIGG success. Until then, here’s to your BIGG success!
George “The Professor” & Mary-Lynn
Co-Founders, BIGG Success
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