5 Important Investment Formulas for Financial Success
Managing your finances can sometimes be overwhelming, as most people lack the proper understanding of how the market functions. This may come in the way of your basic savings and investment decisions. The reluctance to create a budget, use formulas and data, and arrive at decisions can impact your present and future finances.
Apart from professional degrees, investment formulas and strategies are rarely taught in schools and colleges. However, it may be advised to expand your understanding of some concepts to improve your overall financial standing. While there are a number of investment and personal finance formulas out there that can help you, it is recommended to start with the basics. Knowing where you stand in terms of savings, investment returns, debt liabilities, and other similar heads can be an essential step towards achieving financial security and growth. If you need guidance on how to manage your finances and secure your financial future, consult with a professional financial advisor who can advise you on the same.
Here are five financial calculation formulas that can help you understand how to manage money and contribute to better financial decisions for the future:
1. Cash flow
A budget is the foundation of a financial plan. It can help you understand your income sources and allows you to compare them with your expenses to get an accurate picture of your savings. This is also known as cash flow. Calculating your cash flow is simple. Here’s the formula:
Cash flow = Income – Expenses
In order to calculate your cash flow, you need to take a time frame. For instance, if you are calculating your cash flow for January, you will take all your income earned in the month of January. These can include active and passive income sources like your salary, business income, rental income, interest or dividends received from investments, or any other money you may have earned. Next, you need to look at all your expenses. These can include the usual, recurring ones like rent, parking tickets, groceries, gas, and insurance premiums, as well as the non-recurring ones like car repair, buying a kitchen item, etc. In addition, you must include expenses like dining out, movie tickets, flight tickets, etc.
The difference between your income and expenses is your cash flow. A positive number reflects a healthy cash flow. This means you earn more than you spend and are hence able to save more money for your future needs and emergencies. However, a negative cash flow denotes insufficient income to cover your needs. In this case, you either have to find a way to increase your income or lower your expenses. If not, you could end up putting yourself at a lot of financial risk.
Calculating your cash flow for at least three months may be better to get an accurate picture of your income and expenses. A lot of people may spend or earn more or less than usual in a particular month. A longer time frame of three months will help you account for your essential and non-essential expenses and track your income accurately.
2. Capital gains
Understanding your capital gains is another essential personal finance formula you need to know. In simple words, capital gains refer to the profit you earn when you invest your money in the market. For instance, if you buy a stock for $5 and sell it for $7, you make a capital gain of $2. However, since most investors invest in multiple stocks at a time, it can be hard to determine the profit earned from each. Therefore, a better way to calculate your capital yield is by computing your percentage gains. Here’s the formula for this:
Capital gains percentage increase = (Market price – purchase price) / purchase price x 100
For example, if you buy ten stocks of Company Z for $200 and sell them at $220, your capital yield would be:
220 – 200/ 200 x 100 = 10%
Hence, you have earned 10% capital gains. However, if the price of the stock falls to $180 and you decide to sell them, your capital yield would be:
180 – 200/ 200 x 100 = – 10%
In this case, you have suffered a loss of 10% since the value is negative.
Understanding the financial calculations for capital gains helps you plan the redemption of your investments. It also enables you to understand the performance of your stocks and track them over time. The prices of stocks often fluctuate. The capital yield increase or decrease determines whether you need to stay invested or exit the market. It gives you an accurate estimate of the appreciation or depreciation over time. Not only is this essential in computing your profit or loss, but it also compares your yield with inflation. For instance, say you earned a 6% capital yield from a stock in 2022. This may seem like a win. However, with an inflation rate of over 7%, your profits may not really hold any value.
3. Inflation-adjusted return
Inflation increases year-on-year and is defined as the rise in the prices of goods and services in an economy. As mentioned above, inflation can render your earnings less valuable. Therefore, understanding the value of your returns with respect to inflation is essential. The inflation-adjusted return is the value of your investment gains after factoring in inflation. You can calculate the inflation-adjusted return by using the following personal finance formula:
Inflation-adjusted return = [(1 + investment return/ 1+ inflation return) – 1] x 100
So, if you have earned a 9% investment return when the rate of inflation is 4%, your inflation-adjusted return would be:
[(1 + 0.09/ 1+ 0.04) – 1] x 100 = 4.80%
In this case, your actual return after inflation is 4.80%, not 9%, as it would seem.
Understanding the return potential of your investments with regard to inflation is critical in the case of long-term investments. Your money loses value to inflation every year. Therefore, you must plan accordingly. If the rate of return is equal to or lower than the rate of inflation, you will not earn anything. You will also lose money if the inflation rate surpasses your investment return. Therefore, investing in instruments that can deliver inflation-beating returns, such as equity, is advised. Further, it helps to avoid concentrating all your money on investments that provide a return that is not at par with inflation, such as bank accounts, money market accounts, etc. The favorable course of action here is to diversify and keep a suitable asset allocation in equity and debt according to your goals, risk appetite, and inflation trends.
4. Rule of 72
Capital appreciation is one of the primary objectives of investing. Investing increases your money’s value by offering you returns over time. However, investing requires time and patience. Overnight gains are seldom real, and you need to give your money time in the market to plan for varied goals effectively. Every goal has a timeline. For instance, if you had a child in 2022 and are preparing for their college fund, you have another 18 years to accumulate the funds. If you are planning to buy a house in 2035, you have 13 years to save and invest. The timeline of your goals helps you pick the suitable investment that can generate the required funds in time for your use. And the rule of 72 is a useful investment formula that can help you calculate the time it can take for you to reach your goal using a particular investment.
The rule of 72 essentially calculates the number of years required to double the principal invested capital at a given rate of return per annum. Alternatively, it can also be used to determine the rate of return needed to double the money for a given investment term.
- To calculate the number of years required to double the investment at a given rate of return, you need to divide 72 by the rate of return. So, if an investment offers a 9% return, you need to invest for 72/9 = 8 years to see your money double. This means if you invest $2,000 in 2022, it will double to $4,000 in 2030 at a return rate of 9% per annum.
- Likewise, if you want to calculate the rate of return required to double your investment, you need to divide 72 by the number of years you can invest your money. So, if you invest your money for ten years, you will need a rate of return of 72/10 = 7.2% to double your money. This implies if you invest $2,000 in 2022 at the rate of 7.2% per annum for ten years, it will double to $4,000 by 2032.
The rule of 72 is an easy formula for investing. Moreover, it is commonly used by beginners as well as experienced investors. However, it has certain limitations. Firstly, it can only be used if the rate of return is compounded annually. Secondly, it only applies to compound interest and not simple interest. Therefore, it is advised to use the formulas to get an estimate or approximation of the number of years or return rate. The result may not always be accurate but can be used as a general roadmap to plan your investments.
5. Leverage ratio
Debt plays a critical role in your finances. Therefore, understanding where you stand in terms of the money you owe is essential. The leverage ratio can help you calculate the amount of borrowed money versus your income. This enables you to understand how long it will take for you to clear your dues.
Some common forms of debt can include loans, mortgages, credit card dues, etc. On the other hand, your income includes your salary, rental income, business income, etc. You need to take the total of all your debts and income sources and divide them to get your leverage ratio. Here is the formula for the same:
Leverage ratio = Debt / Income
Some financial experts suggest that your overall debt should not be more than 33% of your income. For example, if your debt payments equal $1500 per month and your monthly income is $5,000, your leverage ratio would be
1500/4500 = 0.33 or 33%
The purpose of calculating the leverage ratio is simple. It helps you understand your dependence on debt. If your leverage ratio is high, it indicates not only your high reliance on debt but is also a reminder that your credit score will likely be poor. If you have ongoing debt or are planning to take on a loan or mortgage, it is highly recommended first to check your leverage ratio and see if you are in a position to borrow more money. If you are close to the 33% mark or above it, it may be better to hold on and repay some of your existing debt first. If that is not likely, you may find some extra source of income through a part-time job or work extra hours.
Benefits of using financial calculation formulas
Each of these formulas and several others are helpful for the following reasons:
- Better planning: These formulas help you plan your future needs better. They offer a clear picture of your goals, financial progress, and what needs to be done to get to your target.
- Reduced error: Relying on mathematical formulas instead of speculation or hearsay removes the scope of errors. Data-driven decisions are much more beneficial in the long run. With reduced errors, you may reach your goal sooner and with lesser diversions.
- No emotional decisions: Emotional investing can be problematic. However, when you have precise data and figures in front of you, you are able to see the best course of action clearly. This adds more credibility to your financial plan.
These five personal finance formulas can be helpful in every stage of life. Moreover, they do not require heavy calculations or analysis. They can be simply done with a calculator or even with a pen. It is advised to use these formulas regularly to compute your cash flow, investment needs, profits, and risk. Moreover, it can help to learn other, more intricate formulas that may help you with more advanced investment decisions and tax. Hiring a financial advisor can be helpful in learning, understanding, and using these formulas.
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About Dash Investments
Dash Investments is privately owned by Jonathan Dash and is an independent investment advisory firm, managing private client accounts for individuals and families across America. As a Registered Investment Advisor (RIA) firm with the SEC, they are fiduciaries who put clients’ interests ahead of everything else.
Dash Investments offers a full range of investment advisory and financial services, which are tailored to each client’s unique needs providing institutional-caliber money management services that are based upon a solid, proven research approach. Additionally, each client receives comprehensive financial planning to ensure they are moving toward their financial goals.
CEO & Chief Investment Officer Jonathan Dash has been profiled by The Wall Street Journal, Barron’s, and CNBC as a leader in the investment industry with a track record of creating value for his firm’s clients.