From risk management to savings, money management can help individuals improve their personal finances.
What is money management? From planning monthly investments on the stock market to managing multi-trillion dollar assets by global financial corporations, money management can have a plethora of different meanings.
In general, however, money management can be defined as the process of budgeting, savings, and investments an individual does on a weekly, monthly, or yearly basis. The final goal of money management is the increase in personal net worth while mitigating risk and increasing revenue potential.
There are many rules and tips regarding money management, and in this article we’ll mention some broader concepts as well as a few personal pieces of advice.
Money management also includes risk management, the concept of planning, and mitigating financial risk. Risk is an inherent part of trading, and there are many ways to avoid losing too much, as well as rebounding from a series of unsuccessful transactions.
So let’s delve into what money management is and how it can help increase personal fortune.
What is money management?
The basic concept of money management is planning the future use of assets and liquidity in order to be financially stable and, if possible, increase personal net worth.
Money management in personal finance can help improve someone’s quality of life without an extra salary or a promotion. Personal money management requires discipline and consistency, as well as some concepts of general financial knowledge that we’ll discuss in more depth later.
A single mom planning to save $50 at the end of the month and a multi-national financial institution arranging a $1 trillion investment portfolio for next year are, in principle, doing the same thing.
Corporate money management is the intricate set of business strategies a company must take to reach its goals. While not every individual necessarily has to conduct money management (though it’s thoroughly advised), this becomes a necessity for any company that wants to stay afloat.
Corporate money management ranges from the analysis of assets and liabilities, cash flow, and revenues vs cost. Some companies, however, have in their business model the very idea of money management. That is the case of large financial institutions like Blackrock and Vanguard, which manage global financial assets worth many trillions of dollars.
Money management: 5 things to know to improve personal finances
Before starting to invest, there are a few important actions to take in order to fix personal finances. In principle, money management should help have a solid financial base before starting to invest.
Here are 5 money management tips to improve personal finance:
- Create a realistic monthly budget: each one of us has different spending habits, financial needs, monthly revenues, and essential expenses. The first step of good money management is figuring out a monthly budget according to all these elements,
- Track your spending: having an ideal monthly budget is great, but can be completely useless if the actual expenses exceed predictions. For good money management, it’s crucial to know exactly how much spending is incurred each month,
- Cut unnecessary spending: having a streaming subscription that was last used 6 months ago is not exactly a good money management strategy. Once monthly spending is tracked, it will be easier to see which ones are actually useful and which ones are completely and utterly unnecessary,
- Have long-term spending goals: the ultimate objective of money management is, obviously, to have a better quality of life. A better car, a better house, a better education for children and grandchildren. Dreaming about long-term spending goals is not harmful to money management, it’s the whole point of it,
- Create an investment strategy: however, most long-term goals will not be reachable only through savings. This is why investments are an essential part of money management. However, before delving deep into the trading world, it’s crucial to have an investment strategy in mind.
Finally, there is an important rule to keep in mind for basic money management: the “50-30-20” formula. In short, this formula says that, out of a monthly budget, 50% should be used for essential expenses (rent, groceries…), 30% for personal care (entertainment, hobbies…), and 20% should be saved or invested.
Although 20% of investments can seem too small, the exponential nature of investing will (or at least should) ensure a steady increase in the monthly budget and therefore in monthly investments, and so on.
Money management: 5 things to know to improve investments
Once the basic money management strategy starts helping improve personal finances, it’s finally possible to approach the world of trading and investment.
Investing, however, is a beast of its own, a rabbit hole that can be extremely dangerous if not approached with caution.
Here are 5 useful tips for novice investors:
- Invest in the business, not the stock: the stock market is always extremely volatile, subject to all sorts of positive and negative externalities. If a business is solid, its stock will grow in the long-term even if it faces short-term downfall because of, for example, a global recession,
- Diversify: a crucial piece of advice for first-time traders is to never invest too much into one stock. Diversification mitigates risk and reduces losses,
- Use stop-losses: many trading apps have different technical tools to help reduce loss while investing. The most important of such tools is stop-losses: essentially the trader selects a maximum amount he’s willing to lose, and the app automatically exits the trade once such amount is reached.
- Stick to the plan: there is nothing more frustrating for an investor than exiting a trade right before it starts becoming profitable. No matter how much a stock can go down, it can always go up. The use of stop-losses should be the ones mitigating risk, not short-term panic,
- Keep a trading journal: learning from past mistakes is the best way to never make them again. Keeping a trading journal and studying it on a regular basis will improve the trader’s future strategies and ensure stable growth in experience and success.
Money management: 2 useful formulas
For novice investors, there are two formulas that can help manage trading activities, revealing if a specific trade is worth it or not. The first of such formulas is the so-called “Kelly’s Criterion”:
K = W - (1-W)/R
Where K is the individual operation’s outcome, W is the probability of winning the trade, and R is the probability of losing the trade.
For example, if the trader enters a trade to win $400, but does not want to lose more than $100, he can use Kelly’s criterion to see if this particular trade is worth it. Let’s take, for example, a trade with a 40% of probability winning and a 60% of probability losing:
(0.4 x 400) - (0.6 x 100) = $160 - $60 = $100 of positive outcome
This trade will most likely yield $100 for the trader.
Finally, another useful formula for money management in investments is Williams’ Formula:
K = (C x R) / D
Where K is, once again, the individual operation’s outcome; C is the invested capital, R is the percentage of risk and D is the maximum amount the trader is willing to lose.
Using the same example as before, with the trader investing $200, we get:
($200 x 0.6) / $100 = 1.2% expected outcome = $240
This trade will most likely yield $40 for the trader
These formulas should be considered useful tools, but not absolute certainties. Indeed, other than money management, investing has a wide plethora of tools and technical indicators that help traders guide their processes.
What’s the difference between money management and risk management?
While the two concepts can sometimes have the same meaning, in reality, risk management is a part of money management.
Risk management refers to the mitigation of risk during an investment. As we said before, investing is an inherently risky activity and should be handled with care.
Warren Buffett, history’s richest investor and the world’s fifth richest person, reached a net worth of $119 billion at 93 years old only through “frugal” investments. Warren Buffett believes in patience: putting money on safe and secure investments and waiting for them to inevitably grow.
Other than risk management, however, money management also comprises the concept of savings and position sizing.
The first is self-explanatory: planning one’s future savings according to future revenues. The second, the concept of position sizing, needs a bit of additional explanation.
Position sizing refers again to the world of trading and investments. It’s the concept of planning the capital to invest in each position and its distribution on different assets.
In short, money management is a broad concept that includes risk management, savings, and position sizing.
