Barbara O’Neill, Ph.D., CFP®
Extension Specialist in Financial Resource Management
Rutgers Cooperative Extension
One of the best “small steps” that you can take to improve your finances is to increase your financial knowledge. Research studies have found that people understand food portion sizes better when they are compared to commonly used objects called “portion size measurement aids.” For example, 3 ounces of meat is equivalent in size to a deck of cards and a cup of rice or pasta looks similar to a baseball. Similarly, financial concepts can often be better understood with the use of simple analogies (i.e., comparisons of similarities between things that are otherwise unlike). Below are eight examples for key financial concepts:
Diversification - A financial planner profiled in NAPFA Advisor, a publication for fee-only financial planners, compares an investment portfolio to what we eat. The more food groups and colors on your plate, the more nutrients your body consumes and the healthier you are. If, however, you only ate chocolate every day, your body would suffer from a lack of key nutrients. The same is true for an investment portfolio’s diversification. Investors who put their money in only one type of security (e.g., stock) are at an increased risk for loss of principal due to a lack of variety in their portfolio.
Market Volatility - Volatility refers to the ups and downs in the value of an investment. A good analogy here is someone riding up an escalator while playing with a yo-yo. The fact that the yo-yo goes up and down, like the stock market, doesn’t prevent it from eventually reaching the next level.
Estate Planning - Another NAPFA financial planner uses the analogy of someone getting hit by a beer truck. The mention of beer is used simply to initially lighten the discussion of an otherwise very serious topic. A will and/or testamentary trust are in place in case the truck actually kills someone whose assets need to be distributed and health care proxies and powers of attorney are ready if the truck injures the victim badly.
Financial Planning - A good analogy for the financial planning process is making an airline trip reservation. In order to complete a travel itinerary, travelers must know what airport they are leaving from and flying into (i.e., where they are now and where they want to be), the time frame for their trip (i.e., time deadline to reach a financial goal), and the dollar cost (i.e., amount of money required to reach a financial goal).
Net Worth - A good analogy is the “You are Here” signs along a highway or at a shopping mall or amusement park. The sign provides a point of reference for where you are along a road from Point A to Point B. Similarly, net worth (assets minus debts) indicates where you are on the road to financial security and your progress toward achievement of financial goals. It is a “snapshot” of your finances (another analogy) on a particular day and a benchmark of an individual’s or family’s current financial status.
Interest Rate Risk on Bonds - There is an inverse relationship between interest rates and bond prices called interest rate risk. When interest rates go up, bond prices go down and when interest rates go down, bond prices go up. A good way to visualize this relationship is a see-saw with interest rates on one end and bond prices on the other. Changing the weight on one end of the see-saw causes the other side to shift as well.
Life Insurance - A common analogy used to explain differences between term life insurance and permanent policies, such as whole-life, is to compare life insurance to renting versus buying something such as a home or a car. Buying a term life insurance policy is like renting life insurance. Just like an apartment lease, there is a fixed ending date when coverage ends. With both life insurance and an apartment, a lease or term insurance policy may be able to be extended but generally at a higher future cost. With permanent life insurance, however, policyholders gradually build up cash value much like equity in a home.
Market Indexes - A market value-weighted (capitalization-weighted) index, such as the Standard & Poor’s 500, is like the U. S. House of Representatives where larger states like California and Texas have more votes. An equal-weighted index is like the U.S. Senate where the number of senators per state is the same (2) regardless of size. In an equal weighted index, each stock in the index portfolio has equal weighting.