Principles of Finance

There are six basic principles of finance – risk and return; time value of money; cash flow, profitability and liquidity; diversity and hedging principles. These principles are applicable both at the corporate finance and personal finance levels. Like all principles, they are to guide decisions and behaviour as adherence to them facilitates success in the endeavour, in this instance – financial management.

Risk and return principle talks about the direct relationship between risk and return, that is the higher the risk, the higher the return. Investments that are less risky and give a guarantee on both the principal and return (e.g. money market instruments) usually deliver fewer returns than the riskier ones that cannot even guarantee the safety of the principal (e.g. public and private equities). An investor has to find her place on the risk spectrum and choose investments that fit her risk appetite so she can sleep well. Also, a combination of investments with varying risk: Return profiles would ensure one can enjoy both safe and high return investments.

Time value of money principle refers us to the need to make financial investments early for two main reasons – inflation and opportunity cost. Inflation always erodes the value of money left uninvested. At an annual inflation rate of 10%, N100 next year would only be able to buy what N90 can buy this year. So those who procrastinate erode the buying power of their money. Opportunity cost is another factor that affects the time value of money – if fixed deposit rate is 12% per annum or roughly 1% per month, five hundred thousand naira left sitting idle in a current account for six months has lost a value of N30, 000. If we add inflation of 5% in that period, the N500, 000 has lost 11% of its value – N55, 000. A young investor who delays in commencing a retirement plan stands to lose vast amounts of wealth in his twilight years.

Cash flow principle – this requires that investments be timed to pay cash returns to the investor as and when due. Also, we must not be so prudent that we invest all our salary in shares and fixed deposits, and we do not have enough money to live a good life throughout the month. I know some serious investors who are always broke – rich but broke, this is because they have not obeyed the cash flow principle. Our investments must create sufficient cash flow for daily living.

Profitability and Liquidity Principle reminds us of the need to pay attention to both factors simultaneously. Profitability means that the investment is delivering expected high returns, whilst liquidity refers to the ease of selling the investment and converting it to cash in case of emergencies. Usually the less profitable investments are easiest to convert to cash e.g. money market instruments. Real estate investments, though highly profitable, are notoriously illiquid. The way to obey the profitability and liquidity principle is to have a portfolio of various investments along the liquidity spectrum so that if one investment is liquid but returning low profits, those low returns are balanced by another that is highly profitable but not-so-liquid.

Diversity principle is the principle that readers of this column are all too familiar with – portfolio diversification. Do not put all your eggs in one basket. Diversify along the risk, liquidity and product spectrums. Invest in different asset classes. Invest in products with different maturity dates. Invest in products with different exit profiles. Diversify but ensure that each investment is substantial enough to deliver sizeable returns at any one time. A person investing five hundred thousand naira may not consider diversification yet, but as her portfolio begins to grow there would be a need to invest in additional asset classes.

Hedging principle – this involves investing in such a way as to avoid major losses to one’s investment portfolio if there is an adverse occurrence in one or some of its assets. We learnt in previous articles that diversification itself is a hedging technique. To do this we invest in asset classes that have an inverse relationship – if one is doing very well, the other would not be doing as well; an example of these are money and equities markets products. Therefore, a properly hedged portfolio should have a good combination of both asset classes. Another common form of hedging is Insurance, where any potential losses are transferred to the Underwriter e.g. property insurance.

These six principles have been time tested. Every serious investor should pay attention to them in portfolio management. Happy investing.

 

 

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