People set aside money and make investments for a variety of things, including vacations, house renovations, vehicles, down payments on homes, children’s education, retirement and general security. Some of the goals are long-term, while others are more immediate. Providing retirement income is typically the single largest long-term goal. T
he time horizon will influence the nature of the investment. Savings for a trip are unlikely to be invested in a risky asset class like stocks. Pension savings are unlikely to be made in low-yield investments like bank or building society accounts.
For many people, their pension fund is their largest investment. A pension of Ksh20,000 per year requires a pension fund of Ksh250,000 at an annuity rate of 8% per annum (p.a.). A substantial amount of money must be saved up before a pension can be paid, whether by the employer or the employee. Profitable investing is essential.
The question of how to invest is another one. Many people consider stock market investments, particularly shares, to be excessively risky. But historically, shares have significantly outperformed other investing options like bank accounts. The relative risk issue must be viewed in light of the investor’s time horizon. A one-month viewpoint is considerably different from one that is 40 years in the future. Time diversity is advantageous for stock investments because, over a long period, favorable periods can offset negative ones.
Additionally, from a long-term standpoint, the total income from investments plays a bigger role in determining the total amount accumulated.
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A financial system can be thought of as a collection of institutions, regulations and financial markets with the goal of carrying out several economic functions. Most of those tasks have an immediate impact on how investors behave and make decisions. The financial system serves to transfer funds from people looking to invest to those looking to borrow (the term “borrower” is used loosely here because strictly speaking, businesses that acquire capital by issuing shares are not borrowing but rather selling equity in their businesses).
When investors let others make decisions for them or adopt others’ recommendations, principal-agent issues may occur. For instance, an investor might delegate investment selection to a financial adviser. Choosing assets that provide the biggest commission to the adviser rather than those optimal for the investor carries a risk. This would be an instance of the adviser taking advantage of the investor’s lack of knowledge. Principal refers to the investor, agent to the adviser, and asymmetric information to the informational disparity.
Personal financial planning is organizing one’s finances to maximize spending, financing and investment options. One’s financial goals and objectives are laid out in a personal financial plan. It also discusses the finance, investment and savings strategies used to reach those objectives.
The allocation of money between spending and saving is decided during budgeting. One’s assets will rise and/or their debts will fall as a result of saving. Assets will decline and/or liabilities will rise if spending outpaces income (i.e. there is negative saving). One’s net worth is the difference between their assets and liabilities. Net worth rises with saving (negative saving falls it).
In conclusion, people save and invest for several reasons, from short-term goals like vacations to the important long-term goal of providing retirement income. Their risk tolerance and preferred investment vehicles are determined by the time horizon of the investments. Pension funds often serve as many people’s largest investments, highlighting the importance of wise investing in safeguarding one’s financial future.
Although stock market investments, particularly shares, may seem risky to some, historical evidence shows their potential for substantial long-term returns. Making wise investment decisions and reaching financial goals all require understanding the financial system, dealing with principal-agent issues and engaging in personal financial planning.
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