f there is one thing I could make compulsory for everyone to learn in school, it is personal finance. It is so important that no matter which age, race, color, profession you belong to, you need to know at least the basics of personal finance, especially if you’re going to invest. 

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So many people today struggle because of lack of financial literacy that it is a matter of national concern. The US household debt now stands at a whopping $15.5 trillion, and it is growing at a rapid pace. 

However, national debt and all are macroeconomics concepts that are of little concern to us. We are here to talk about units of microeconomics, i.e., you. 

If you’re reading this blog, I assume that you’re someone interested in personal finance and investing. And if you are, you’re at the right place because we’re going to discuss, in-depth, what are the personal finance basics you must know before you go about investing. 

But before that, what exactly is personal finance? In very simple terms, it is the management of your money, including income, expenses, savings, investments, mortgages, credit, and all other activities you do with money. 

It is not just limited to budgeting your expenses for the month, as the popular belief goes. It encompasses everything right from earning the money to spending & growing it. 

Today, we’ll explore how to calculate your net worth, whether you’re cash flow positive or negative, what is your risk tolerance, and other personal finance basics.

Your Risk Tolerance 

Not knowing your risk tolerance when you start investing is the reason why investors panic, catch FOMO, get stressed out, and get stuck to their screen all day to check the markets and lose their money. 

The first step you need to take in order to start investing is you need to understand your risk tolerance. What is the risk you’re ready to take in order to earn a particular return? 

Knowing what your risk tolerance is will help you remain patient, follow the strategy that you’ll create based on your risk tolerance, go about your life without feeling the need to check the markets every two minutes, and just live a stress-free life. 

In fact, having a stress-free life, at least from the finance side of things, is the biggest benefit of knowing your risk tolerance. 

Because no matter how much money you make, if you’re constantly stressed out and if it’s going to cause you different mental issues, then it is not worth it.

So, how do you gauge your risk tolerance? Is there a calculator, strategy, or anything like that? Well, yes. Let’s look at it. 

Your Balance Sheet 

A balance sheet? What does that even mean? First of all, let’s get rid of this intimidating term and let’s replace it with something that we all can easily comprehend. 

Instead of a balance sheet, let’s call it the “my current money situation” statement. It is the same as the balance sheets they make for companies, which also tells about a company’s current financial situation. 

So pick a pen and a paper and make two columns on it. Name one as “What I own” (assets), and the other one as “What I owe” (liabilities).

In the first column, write down everything you own that holds value, or that can be sold in some kind of marketplace in exchange for money, along with their approximate value. 

It includes things like your 401k, IRA, education savings, checking account, and even your personal assets like your car, home, furniture, boat, and even clothing. 

On the second column, note down all your liabilities, meaning everything that you need to pay off. It includes things like your credit card debt, your student loan debt, mortgages, unpaid bills, etc. 

Fill up your balance sheet completely to the best of your knowledge and understanding. And once you’re done, we’ll calculate your net worth. 

What is your net worth? Your net worth is the difference between your asset column and your liabilities column. It can be positive, negative, or zero. Your net worth shows you where you stand today financially. 

If your net worth is positive, then that is good news because that means you’re ready to start investing. But if your net worth is zero or negative, it means you first need to increase your income before you can start investing. 

Income &  Expenses Statement

We just talked about your balance sheet or your statement of current financial situation, and it gave you your net worth, which is a really interesting and important number to know.

But it also has some limitations. If you only look at your balance sheet, you’re not going to understand why or how an asset increased in its value- did you buy more, did the asset appreciate, did it depreciate? Also, why or how did an asset or liability appear on your balance sheet- did you purchase an asset, did you inherit one, did you lose an asset?

Basically, it doesn’t explain the changes in your net worth. To overcome this limitation, you need something called an income & expenses statement, which will explain the changes between your balance sheets every year. 

And to make it easy for everyone to understand, let’s call it “my cash flow situation statement” instead of a statement of income & expenses. 

So, let’s pick up the pen & paper again and create three columns this time, namely income, savings, and expenses. 

As the name suggests, the first side will consist of every source from where money is coming in. So, for example, maybe you have a salary, interest income from the bank, side income from some fixed assets, and dividends if you’re already investing. They all go into the income side. 

One thing to remember is that your unrealized income does not go into the income side. So if you’ve gains in your portfolio that you’re yet to book, don’t include them here. 

The second column is called savings and this is where all of your savings will go. For example, any deposit to your retirement account, any deposit to your education savings, any deposit to a brokerage account, the money you have at the bank. 

Finally, the third column is expenses, where all the places your money is going out to will go. It’s easier to calculate if you divide your expenses into fixed expenses and variable expenses. 

Again, you’ll either get a positive or a negative number. If you’re cash flow positive, then congratulations because your risk tolerance can be much higher than someone who is cash flow negative. 

Your Willingness To Take A Risk

So all that we’ve talked about until now is the quantitative side of things- everything that is related to numbers and maths. 

But your risk tolerance isn’t just based on some numbers. It is a combination of both quantitative and qualitative factors, such as your willingness to take a risk, your age, current conditions, and future aspirations. 

If you’re a person with a positive net worth, whose cash flow is positive as well, and you’re bringing in like six figures in income per month, then your risk tolerance according to these numbers is very high. 

But what if you’re a defensive investor by nature, have a family of six dependent on you, or you’re approaching closer to your retirement. That would reduce your risk tolerance by a lot. 

Since your risk tolerance is a combination of qualitative and quantitative factors, if according to the numbers, your risk tolerance is high, and according to qualitative factors, it is low, then your overall risk tolerance is moderate. 

Knowing your risk tolerance will cover almost all of the personal finance basics you need, and will help you chill and invest with confidence in the assets of your choice.