Finance has a language of its own. Most of that if dry is boring - right up to the point where it hits your wallet.
It makes sense for anyone, whether they are investors or not, to understand these common points of confusion:
- Nominal versus Effective Interest Rate
You often see two sets of interest rates on a banking product. The nominal interest rate, and the Effective Interest Rate (EIR). What’s the difference between the two?
Well the nominal interest rate is just the stated interest rate. It doesn’t take into consideration the effect of compounding. There is a significant difference between the two. For example:
Assume you have a form of loan that doesn’t compound (a vanilla bond is a good example). You are owed $5,000, after a period of 10 years. If the interest is 5 per cent per annum ($250 per year), you would get $7,500 at the end of 10 years.
But if the interest was compounding, you would get a very different result. You would no longer be getting just $250 per year. You would get $250 in interest in the first year, but in the subsequent year you would get $262.50 (five per cent of $5,250), and in the third year you would get $275.60 in interest (five per cent of $5,512), and so on. You’d have $8,144.47 at the end of 10 years - a difference of around $644.70.
This is why, when you take a loan, the bank is required to publish both the nominal interest rate, and the EIR next to it. You should take note that the EIR is the genuine rate you are paying.
2. Median versus Average
Unless you paid careful attention in school, you have probably forgotten or missed the difference between a median and an average. This slip-up can be used to mislead you.
For example, say you are asked to join a marketing scheme, and to help sell cruises. When you ask how much you can earn, you are told the average amount is $3,950 per month. Does that mean the majority of the sellers earn that much?
Probably not. Consider this:
Say there are 100 sellers in the scheme. 90 of the sellers only make $500 a month. However, 10 of the sellers are tremendously successful, not least because they take a portion of the sales made by the other 90 people (this is how many Multi-Level Marketing schemes work. So now:
90 people earn $500 a month from the scheme. 10 people manage to earn $35,000 a month from the scheme. What is the average?
($500 x 90) + ($35,000 x 10) / 100 people = $3,950.
The average is indeed $3,950 per month. However, we know for a fact that 90 per cent of the sellers don’t earn anywhere close to this amount! They only earn $500 per month.
This is because the unusually high earnings from those at the top of the scheme (the ones earning $35,000 per month) greatly skew the results.
By using the median, we lay out all the numbers in a row, and knock off the numbers from both ends until we come to the middle. In the above example, we would lay off the earnings of all the sellers in the straight line, and eliminate one number from each end until we come to the number in the centre (which would be $500).
This is why reputable agencies like the Ministry of Manpower always report median income, when trying to give a sense of how much the typical Singaporean earns. An average income would be a highly misleading figure.
Bear this in mind when you are told the “average” amount someone can make from a product, or the “average” pay for a particular job.
3. Capital Protection Versus Guarantees Against Loss
Capital protection often sounds like a great form of safety. In fact, many advertisements like to boast that a financial product is safe precisely because of capital protection features.
In reality, capital protection is no guarantee against significant losses.
Capital protection means that only the initial amount you invest is protected. The rest of it is not guaranteed. Now, consider what happens if you invest a large portion of your life savings (say $100,000) in a structured deposit, which promises returns of five per cent per annum. You must commit the money for a period of 10 years. You are warned the risk is high, but you have capital protection.
After nine years, you receive a call that something has gone wrong. The structured deposit has been cancelled (the bank is “calling” the deposit). You will only be receiving your initial capital back.
Have you lost money? Quite definitely.
At the end of nine years, the amount of money the deposit has accumulated is around $155,133. By getting back only your initial capital, you have wasted nine years of growth, and lost over $55,000.
All that time, you could have had the money invested in a safer product. And remember that over nine years, the rate of inflation would have significantly lowered the real purchasing power of your initial $100,000.
Capital protection is of some use, but don’t be under the impression that you are perfectly defended against losses.
4. High Volatility
Many lay investors are scared off by the term volatility, or risk. It’s important to remember, however, that high volatility does not inherently mean something is bad.
High volatility means there are large price movements in either direction. A volatile asset can fall significantly in price, or it can rise significantly in price. Without volatility, profit is impossible (if all prices are permanently fixed, how could you ever find a discount, or run a business?)
Some degree of volatility is needed in order to grow your money. As such, many financial advisors will suggest mixing in a small amount of volatile assets. One such approach, called the barbell strategy, is to have 90 per cent of your assets in safe products (like fixed deposits), and 10 per cent in highly volatile products.
In this way, losses from the volatile products cannot significantly damage your wealth (they account for just 10 per cent). But in the off chance that they pay off, the high volatility means they could triple or quadruple returns, and the high profits will offset the slow growth of safer products.
To put it simply, do not assume that high volatility is all bad. The key is to balance your portfolio by getting the right mix.
5. The “Free” in Interest-Free
There are many misconceptions about how an interest free loan works, particularly with regard to credit cards.
If you use a balance transfer, the interest free option is not without cost. This is the balance transfer fee, which is a percentage of the amount transferred. So if you shift a $2,000 debt to another card, at a processing fee of 4.5 per cent, your total debt grows to $2,090.
At the end of the six month interest free period, you again make a balance transfer, incurring another 4.5 per cent. Now your debt is $2,184.
This is why you cannot evade paying your credit card forever, by repeatedly making balance transfers. It is still growing, even if you hop from one interest free period to the next.
6. Credit Card Instalment Plans
Many credit cards allow you to make instalment plans on big purchases, such as televisions or laptops. For example, you may see an offer from your card that says “Interest free 12 month instalment plan” for a $10,000 plasma screen TV.
You might conclude that, when you buy the TV, the first instalment of around $833 is charged to your credit card. That is not how it works.
When you buy the TV, the whole $10,000 is charged to your credit card right away. If it is interest free, you are simply not paying the interest rate on this specific purchase. But the entirety of the purchase has been charged to the card, and counts toward your credit ceiling - that’s why you might find your card repeatedly declined after such a large purchase.
Also, remember that there is a minimum repayment sum. If the minimum repayment is three per cent of the amount owed, buying that TV raises the minimum repayment to at least $300 per month. You still need to pay this or face late charges.
7. Tactical versus Strategic Asset Allocation
Asset allocation refers to the way a portfolio is balanced. If you have a financial advisor or wealth manager, this is often done for you. The allocation is often described to you in simplified terms (e.g. 10 per cent cash, 60 per cent shares, 30 per cent bonds).
Strategic asset allocation usually refers to a long term, buy-and-hold strategy. These principles require portfolios that are tweaked periodically, often every six months (but this can vary).
Sometimes however, you may hear the term tactical asset allocation. The technical sounding term is sometimes used to avoid alarming you, along with the term “actively managed”. Make no mistake, it refers - to a limited degree - to market timing. That is, the risky process of trying to guess market movements, in order to buy low and sell high.
Some salespeople know that concepts can be offputting to the risk averse, hence the use of the more obscure terminology. While it doesn’t immediately mean something bad or outrageously risky, be aware that tactical asset allocation reflects on active, more aggressive approaches.
This article was contributed by SingSaver.com.sg, Singapore’s leading personal finance comparison platform for credit cards and personal loans.