For most of us, almost no day goes by without us having to make a financial decision. Most of them are trivial and do not require much analysis. But there are times when we need to make a decision which is either going to bring in a significant amount of money or cost us a significant amount. In making those decisions, there are a set of tools that will help us to think clearly and make the decision which makes the most financial sense. In this post I will try to share the method for doing that.
Financial decisions are among the most important decisions any individual will make but they are also relatively easier to make than other decisions because the objective is to make the most money possible. That is a simple goal. Compare this to decisions about marriage, children or health and you realise that those are far more complicated.
So let’s get down to how to actually make a financial decision like what to invest in; whether to pay off a loan with some cash you’ve got or to keep that money and keep paying the loan off gradually; whether to rent a place or get a mortgage; whether to leave a job and go to school; or the many countless examples of financial decisions that we come across.
It’s obvious that the first thing you should look out for is what you stand to gain. In finance, this is called the return. But you should not only look at the gain, you should look at what your money could have got you if you had not made the decision you are making. For example, if you decide to start a business with your savings, you are giving up the interest you could have earned in your savings account. Economists call the option that was given up the opportunity cost. With this information, we can conclude that the financial option one should pick should provide the greatest return after factoring in the opportunity cost.
But that is not all. We know that we cannot always tell what the outcome of a financial decision will be. For example, if you are deciding between starting a business or going to school, you cannot know exactly what your business would be making or the kind of money your education would command on the job market. The amount of money you will end up making could be radically different from what you thought you would make. This kind of uncertainty is what financial analysts call risk. Each option has a different risk factor to it and you should take that into consideration when you are making your financial decision.
For the purpose of simplicity, I will introduce just one last factor – time value of money. This is simply the idea that money to be received in the future is worth less than money you have right now. This is because money you have right now can earn interest and generate more money for you. Also because things generally get more expensive over time, the goods and services an amount of money can buy gets fewer with time. In the context of a financial decision, what this means is that the longer the period you have to wait to receive your return, the higher the return you should demand.
Putting all of these together, we can come up with the rule which should guide financial decisions. You should pick the option which offers the highest return after considering your opportunity cost and which has the lowest risk. And the longer you will have to wait to enjoy your return, the more that return has to be.
Now these factors are not the only things you should consider when making a financial decision. Financial decisions range from the simple to the overly complex, but if you apply these rules the options will look clearer and you will be more likely to make the decision which makes the most financial sense.