April is Financial Literacy Month, and our goal is to help you raise your money IQ. In this series, we'll tackle key economic concepts -- ones that affect your everyday finances and investments -- to help you make smarter choices with every dollar decision you face.
Today's term: benchmarks.
You probably think of a benchmark as simply a baseline for comparison, something you can measure performance or judge quality against -- and if so, you're right. But if you're like many people, you don't apply benchmarking sufficiently in your financial and nonfinancial life, and you may suffer for that.
In Business and Investing
There are many forms of benchmarking, especially in the business world. If you're developing a new electronic device, you'll likely benchmark it against existing similar products, as you aim to meet or exceed their capabilities. Computer-related companies, for example, measure their products' or systems' effectiveness against industry benchmarks or standout performers. In the auto industry, Volkswagen (VLKAY) has developed a new modular car-building methodology, and both Ford (F) and Toyota (TM) are already using it as a benchmark against which to measure themselves.
In the investing arena, benchmarks are also critical. You may have noticed, for example, when reviewing documents related to mutual funds that you own, that the fund companies will report their performance and will compare it to a benchmark. A stock fund, for instance, might show how it has outperformed (or underperformed) the S&P 500. A bond fund might compare its performance to a bond index.
Many of us might glance at those comparisons and then move on, or perhaps we'll just ignore them completely. That's a mistake.
Consider, for example, that within the world of mutual funds, it's hard to find lower fees than those for some broad-market index funds, such as S&P 500 index funds. The Vanguard 500 Index Fund (VFINX), for example, charges just 0.17 percent annually. In contrast, many stock mutual funds, especially those actively managed by pros instead of those that track relatively stable indexes, charge more than 1 percent, and sometimes much more.
Thus, index funds serve a critical role as benchmarks: If your investments are not beating their benchmarks, then it may be time to move your money elsewhere -- perhaps into an investment that tracks that benchmark.
Correct Use of Benchmarks
There are some common mistakes people make when using benchmarks to judge the performance of their investments.
One is taking a short-term view. Over a few months or a year or two, a fund might do unusually well or poorly. So you have to look at the big picture and measure performance with an eye on the long-term.
Be sure to use the right benchmark, too. If you're invested in a small-cap mutual fund, for example, and you're comparing its results with the S&P 500, that's an apples-and-oranges proposition, since the S&P 500 is made up of bigger companies that generally can't grow as rapidly as successful small ones.
Check out the average annual returns for the S&P 500 and the small-cap-focused Russell 2000 index:
Data: Morningstar.com, Russell.com.
Also, be sure to review the performance of your whole portfolio regularly, and to compare apples to apples. For example, if your portfolio is 50 percent stocks and 50 percent bonds, you shouldn't be comparing its overall performance to the S&P 500, as that's 100 percent stock-based.
In Your Life
Benchmarks can involve other parts of your life, too. If you're buying a home, for example, you'd do well to compare it with the rest of the neighborhood, to make sure it's not the best or worst house on the block, as those won't always offer the best value.
But trying to live up to the benchmarks of celebrity lives or even our seemingly well-off neighbors can lead you and your finances astray. If you're living beyond your means by trying to keep with the Joneses, and you're accumulating a lot of credit card debt, you're in deep danger. And, don't forget, those folks you're trying to compete with may be hiding financial troubles themselves.
Learning about some simple economic concepts can make you a better financial and nonfinancial thinker and decision maker.
Motley Fool contributor Selena Maranjian owns shares of Ford. The Motley Fool recommends Ford. The Motley Fool owns shares of Ford. Try any of our newsletter services free for 30 days.
In a nutshell, net worth is what you get when you subtract liabilities from assets -- what you owe from what you own. Like many economic and financial terms, net worth can apply in a variety of situations.
If you're evaluating a company for your portfolio,you might glance at its balance sheet to get a handle on its net worth. Balance sheets break out assets (such as cash, inventory, and receivables) and liabilities (such as debt and accounts payable). Subtracting the latter from the former gives you net worth, which is also referred to in this context as shareholders' equity or book value.
Here's an example: As of the end of 2012, IBM's (IBM) assets totaled $119 billion, and its liabilities totaled $100 billion. Thus, its net worth, or shareholders' equity, was $19 billion.
You probably think you've got the term down pat: Inflation means prices rising over time. Well, yes, that's pretty much right. But there's much more to inflation, and it's much more relevant to your life than you might think. Inflation can go in the opposite direction, for example, and it can spiral out of control.
Inflation is about purchasing power. It's a way to measure the changing purchasing power of our currency by tracking changes in the prices of things we buy. The national banks of various countries try to keep inflation under control through their actions and policies (such as via the interest rates they set); many aim for an annual inflation rate of about 2 percent to 3 percent.
While the concept of inflation seems simple it's actually a bit more complicated. Read more on inflation here.
Most of us are familiar with the term, and have a basic grasp of it. It refers to how a project or decision might be evaluated, comparing its costs with its benefits. In many cases, it's a like a quantified pros-and-cons list.
Applying cost-benefit analyses in the business world and your own personal finances can be very effective, helping decision makers avoid just going with their gut or with very rough calculations.
Simply put, it's what you give up in order to do something. Imagine, for example, that you dream of becoming an engineer or a chef. If you opt to become a chef, you give up the experience of being an engineer and all that goes with it. That's an opportunity cost of becoming a chef.
Opportunity cost is also often defined, more specifically, as the highest-value opportunity forgone. So let's say you could have become a brain surgeon, earning $250,000 per year, instead of a chef earning $50,000. In that scenario, your opportunity cost, salary-wise, is $200,000. (Of course, you should also consider factors such as your enjoyment of your chosen profession.)
Most folks are familiar with the concept of supply and demand, but most of us also don't give it much thought, which is a mistake. That's because it applies to much more than just business.
First, to review. In basic economics, the law of supply and demand influences prices. If supply of an item is abundant, that will pressure the price downward, and vice versa. In practice, imagine that you're the only one in town selling shoehorns. Because consumers don't have any other places to buy the product, that gives you some pricing power. But if other stores in town start carrying shoehorns, you may have to drop your price to keep customers coming.
Read about the differences of supply and demand in the stock market and in our own lives here.
As the name suggests, sunk cost refers to money that has already been invested in something, money that can't be recovered. Too often, we factor that expense into our financial decision-making when we shouldn't.
Let's say you've spent $40 on a nonrefundable ticket to the theater for tomorrow night. And you're suddenly invited to play board games at a friend's house that same evening. You might think that you should go to the theater -- after all, you spent that $40 -- even though what you'd rather do is hang out with your friends and play games. The $40 is a sunk cost. It's spent, whether you go see the play or not, and the money doesn't know the difference. So you should do whatever you would rather do.
In the most basic sense, asset allocation is simply how one's assets are divided among different asset classes, such as cash, stocks, bonds, real estate, and so on -- even insurance investments, commodities, collectibles, and other categories count.
But the term also refers to an investment strategy -- one that can reduce risk through diversification.
Clearly, having all your money in any one asset class can be risky. In 2008, the S&P 500 plunged 37 percent. If you'd held all your assets in an S&P 500 index fund, your net worth would have taken a big hit that year.
Given the harrowing ride we've been on in recent years, you might think that holding cash is the best way to protect your assets from outside forces. Think again.
The concept of interest is familiar to most of us. We know that with many bank accounts, for example, we earn some interest -- though it's rather paltry these days.
But there are several kinds of interest that are calculated and represented quite differently than simple interest. Compound interest is -- pardon the pun -- one of the more interesting ones.
First, let's start with simple interest. Here's how it works: Let's say that you've parked $1,000 in an account somewhere, earning 10 percent per year in simple interest. In year one, you'll collect $100, bringing your total to $1,100. Great, eh? In year two, you get... $100. That brings your total to $1,200. In year three, you're at $1,300. You're probably catching on to the idea by now. You keep earning that interest rate off your initial principal.
Enter compound interest, which is far more exciting.
The meaning of the term varies depending on context. In the accounting world, for example, it refers to the change in a company's cash level over a specific period of time. If a company's cash level rises during that period, it's exhibiting positive cash flow. If it shrinks, negative cash flow.
When investors study companies to see if they might be good fits for their portfolios, they may assess "free cash flow." That reflects a company's cash flow from its operations after it pays all its expenses. Free cash flow can be viewed as the lifeblood of a company.
When it comes to financial matters, we all know what risk is -- the possibility of losing your hard-earned cash. And most of us understand that a return is what you make on an investment. What many people don't understand, though, is the relationship between the two.
The relationship between risk and return is often represented by a trade-off. In general, the more risk you take on, the greater your possible return. Think of lottery tickets, for example. They involve a very high risk (of losing your money) and the possibility of an extremely high reward (the giant check with lots of zeroes). Or penny stocks: They're also very risky and yet seem full of amazing potential.
At the other end of the spectrum are options such as a savings account at your bank, or buying government bonds. They're quite low-risk, but you're not going to make a mint on them, either -- at least not these days, with interest rates so low.