Our system doesn’t do a great job of teaching financial literacy and that can be harmful to the public (“Dollars & sense,” Insight, Nov. 25). At bottom, finance is mostly about concepts, which means it is about words. Some fundamentals can be taught, or at least, the issues raised so a diligent reader can seek answers from the mountain of finance information out there.
Can you read a financial statement? The income statement is money coming in, minus money going out, over a period of time, which should equal a positive or negative net income. The balance sheet is a statement of what you own (assets) compared against what you owe (liabilities). If the assets are bigger than the liabilities, you should have some net worth left for yourself, sometimes called “equity.”
Now the tricky part: What is the connection between the income statement and the balance sheet? Answer: At year’s end, if you have net income from the income statement, it adds to the balance sheet assets and net worth. If you have a net loss on the income statement, it reduces assets and net worth.
Can you name the four types of finance? Debt, equity (stocks), insurance and tax. Let’s take each in turn.
>> Debt is created when you borrow money from someone. Eventually, you have to pay it back with interest, which can be thought of as a fee or rent for having the use of that money. Interest can be fixed or adjustable. It is worth researching what happens to the price (or face value) of debt that has a fixed rate of interest when the interest rate levels in market go up and down.
>> Equity means ownership. Stocks are equity interests in a corporation. The key is to recognize that the value of your stock in the marketplace may not have much to do with the net worth on the balance sheet of the corporation. The value of your stock is a function of the market’s perception of the future earning potential of the corporation.
Stocks can be volatile and unpredictable. It can be difficult for a corporation to maintain its competitive advantage over time and often much of that advantage is due to the management team. Also, while the general trend of the U.S. stock market is upwards over a 40-year period, if you look at segments of five years or less, the trend can look very different. Past performance does not guarantee future results. And remember: When owning stocks, nothing happens to you just because the market goes up or down. You are only affected when you sell your stock and have “realized” gains or losses.
> Insurance is risk transfer and risk pooling. Risk transfer means that you, the policyholder, transfer some of your risk to the insurance company. Risk pooling means that each year the insurance company is aggregating premiums from all of its policyholders to cover the losses they have in that year. The majority of those policyholders don’t have a significant loss — and they subsidize those who do. Insurance works because there is an inverse relationship between the frequency and severity of loss. Big losses happen infrequently; small losses happen frequently. The ideal use of insurance isn’t for a baseball through your window, but for the day your entire house burns down.
>> Tax is money taken by the government from private persons and businesses to finance things that benefit the general public. There is a relationship between the amount the government does for you and the amount you pay in taxes. But watch out for government debt.
Becoming more financially literate is important for Hawaii’s young people, just as it is for many adults. Knowing the fundamentals can lead to expertise, and that can pay off, big time.
Lloyd Lim started his career as a bond lawyer and later worked in catastrophe and health insurance.
