Twelve Key Elements of Practical Personal Finance

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Twelve Key Elements of Practical Personal Finance
Common Sense Economics James Gwartney, Richard L.
Stroup, and Dwight R. Lee CommonSenseEconomics.com
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Why Is There Financial Insecurity in America?

• Do You Think It Is Because Incomes Are Low?
• See next slide.

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U.S. Income Is Rising and Has Never Been Higher
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Consumption Per Person Is Also Growing
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Financial Insecurity

• Lets take a look at how households divide their
  income between consumption and savings.
• Remember, saving helps households prepare for
  surprise expenditures.

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U.S. Saving Rates Are Falling While Consumption
Rates Are Rising
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And Interest on Household Debt as a Percentage of
Income
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Summarizing Trends in Household Finance

• While real income per person is rising,
• The savings rate is falling, and
• Debt is increasing.
• A failure to save regularly, use credit cards
  prudently, consume wisely and invest
  strategically are largely responsible for
  financial insecurity in America.
• These trends highlight why it is important to get
  control of your finances before they get control
  of you.

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Planning to Achieve Financial Security

• Set financial goals for the short and long run.
• Put plans in place to achieve these goals.
• Work hard and work smart.

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Why Do We Need or Want Financial Security?

• Financial security will help us live less
  stressful lives and pursue other goals
• Less Conflict in Marriage
• Better Health
• Family
• Religious Goals
• Education
• Retirement
• Charitable Contributions

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If you don't know where you are going, you might
wind up someplace else. Yogi Berra
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Practical Element of Personal Finance 1

• Discover your comparative advantage.

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Comparative Advantage

• Discover what you can produce at a lower cost
  than others. Think opportunity costs!
• Find out what others value and know how much they
  are willing to pay you to produce your low cost
  good or service.
• Trade your valuable services and goods for
  income.
• Use that income to buy those goods that would be
  expensive for you to produce and save to achieve
  other financial goals.
• Exchange is mutually advantageous! Consider the
  scenario presented in the next slide.

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Farmer John vs. Nurse Kelly Can They Gain From
Specialization and Trade?
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Whats Your Comparative Advantage?

• Think about what you are good at doing and enjoy.
  Is this something others value highly? How do
  you know?
• Is your educational training helping you develop
  a comparative advantage?

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Practical Element of Personal Finance 2

• Be entrepreneurial.
• In a market economy, people maximize their income
  by providing services and goods others value.
  They get ahead by discovering better ways of
  doing things in and outside their workplaces.

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The Entrepreneur Next Door

• Entrepreneurs actively pursue discovering better
  ways of doing things.
• They act quickly and strategically on new
  opportunities.
• Entrepreneurs fuel economic growth and
  development!

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Entrepreneurs Success

• Entrepreneurial talent the ability to discover
• new products that are highly valued relative to
  costs,
• cost-reducing production methods, and
• profitable opportunities that others overlook.
• Tolerance for risk Entrepreneurial activity and
  self-employment are riskier than being employed
  by a proprietor, partnership or corporation. But
  greater risk can translate into higher income and
  more wealth.

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Entrepreneurs Success (cont.)

• High Savings Rates Entrepreneurs have high
  savings rates. Often they invest in their
  businesses, adding to their wealth.
• Work Hard and Smart Entrepreneurs, business
  owners and independent contractors tend to work
  longer hours and more strategically.

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Practical Element of Personal Finance 3

• Spend Less Than You Earn

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Why Should You Save?

• Increase your wealth.
• Live a less stressful, more financially free
  life.
• Achieve high consumption levels in the future.

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How Do You Start?

• Just do it.
• Make savings a part of your monthly plans, e.g.
  channel a designated amount into an electronic
  savings account.
• Develop a budget and figure out how to reduce
  discretionary spending.
• Buy used or sale items and place the savings
  into an account.

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Just Do It!!!

• Exert the willpower to save now.
• It is unlikely that you will do so later.
• If you wait to save until your income goes up, it
  will be extremely costly in terms of the funds
  available at retirement.

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Coffee Anyone?

• Many people buy one premium cup of coffee each
  day. Assume each cup costs 4. If they could
  earn a 7 return, how much could this coffee
  money earn over a 50 year period if saved or
  invested?
• Nothing. The coffee is consumed!
• 1,460
• 73,000
• 443,918

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Strategic Savings

• Tax deferred savings.
• Automatically deduct savings from your gross
  income, thereby reducing your taxable net income.
• There are many types of tax-deferred savings
  plans traditional IRAs, 401(k) plans, 403(b)
  plans, etc.
• Think of creative ways to spend less.
• Use coupons and allocate savings into an account.
• Strategically purchase used items.
• Shop when there are bargain sales and promotions.
• Budget, budget and budget. Spend less and save
  more.

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Practical Element of Personal Finance 4

• Dont finance anything for
• longer than its useful life.

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Financing Consumption

• Purchase on credit only when you are buying
  revenue generating assets in order to earn
  positive net returns.
• Financing makes it possible for you to spend now
  and pay later. Dont build up debt unless it is
  strategic!

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Good Debt. When can you finance?

• When goods and services financed now promise to
  yield a return greater than cost (principal and
  interest).
• Residential home
• Education
• Under certain circumstances, these assets
  generate income and wealth over time. They can
  help increase your net worth (assets less
  liabilities).

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What Should Not Be Financed?

• Nondurables Goods that are consumed or items
  that lose their value quickly.
• Once consumed, food, clothing and concerts are
  gone. Payments will linger if not paid for when
  purchased.

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Practical Element of Personal Finance 5

• Get More Out of Your Money
• 1. Avoid credit card debt.
• 2. Consider purchasing used items.

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Paint a Bright Future!!!

• Save today and spend in the future!
• Use credit cards wisely and pay them off
  immediately.
• Build a strong credit history in order to get the
  best interest rates when financing a house, car
  and other big ticket items.

ordinary people can have lots of nice things
and still accumulate a lot of money.
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Credit Card Convenience

• Paying with a credit card is NOT spending your
  own money, but borrowing someone elses IF you do
  not pay right away.
• Interest rates on credit cards are high because
  they are unsecured. Interest charges will
  outstrip what you can earn on savings and
  investments.
• Think of your credit card as an extension of your
  checking accountAlways pay your credit card bill
  in full.

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You paid how much?

• You buy new clothes, go to a once-in-a-life-time
  concert with friends and buy more and more until
  you gradually hit your credit limit of 2000 at
  13.4. You can only manage to pay the minimum of
  50 each month.
• How many months will it take you to pay the
  credit card off?
• 40, 80, 120, or 166 months?
• 166 months!
• How much does the 2000 end up costing you in
  interest?
• 0, 130.40, about 260, over 1300?
• 1300 in interest! And the items costing 2000
  are gone!

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Buy UsedWhen Strategic

• Is buying new worth it?
• Depreciation costs make new cars expensive. They
  depreciate substantially when driven off the lot
  and they depreciate rapidly in the first three
  years.
• Used cars may have slightly higher maintenance
  costs but their depreciation costs are much
  lower.
• Buy used! Visit Edmunds.com and compare.

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Do Credit Card Companies Prey on the Financially
Illiterate and Undisciplined?

• Advertisement of a credit card company You
  want it all, and you want it now! Our credit
  card will make it possible.
• Is this a lie?
• Are goods scarce? Can we have everything?
• How will going deeper into debt affect your
  wealth and future consumption?

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Practical Element of Personal Finance 6

• Pay into a real-world savings account every
  month.

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Rainy Days the Real World

• Life is full of surprises, and theyre usually
  expensive!
• Cars break down.
• Heaters and air conditioners go.
• People get sick or injured.

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Plan For Your Rainy Days!

• The only surprise is the timing. So put a plan
  in place!
• Purchase peace of mind by building a savings
  cushion.
• Make contributions regularly and a mandatory part
  of your monthly budget!

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Practical Element of Personal Finance 7

• Put the power of compound interest to work for
  you.

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Its a Miracle!!!

• Save and invest regularly. There is a huge
  payoff!
• Compound interest allows you to earn more and
  more interest on interest and your investment!

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The Rule of 70

• Determine how long it takes to double your
  investment.
• Place funds in an investment and let it grow over
  time.
• Divide 70 by the expected rate of return (R) and
  see how long it takes to double in size.
• 70 Number of years R to double
• When R 7, your investment will double in?
• 10 years (70/7)

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Take A Closer Look

• Save 2000 at the age of 16 and place it in an
  investment that promises a 10 percent return.
• How long will it take you to generate 4000 in
  funds?
• 7 years (70/10)
• So at the age of 23 you will have 4000.
• How much will you have at the age of 30 if you
  continue to invest the funds?
• 8,000 (4000 4000)
• Age 37?
• 16,000
• Age 51?
• 64,000 (16,000 16,000 32,000)

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Practical Element of Personal Finance 8

• Diversify - dont put all of your eggs in one
  basket.

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Accumulate Wealth and Gain Financial Security

• Investments involve risk, especially in the
  short-run.
• Manage this risk by building a broad portfolio
  based on diversification.
• Historically, long term returns on stocks have
  been attractive. But diversification is
  essential.
• Hold a large number of unrelated stocks for a
  lengthy period of time. Put the law of large
  numbers to work for you!

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The Law of Large Numbers

• The law of large numbers states that while some
  of the investments in a diversified portfolio
  will do poorly, others will do well.
• The performance of the latter will offset that of
  the former,
• and
• The rate of return will converge toward the
  historic average.

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Avoid Double Jeopardy

• Does your employer offer a company stock-based
  retirement program or agree to match any income
  used to purchase company stock if held for a
  period of time?
• IF your company is well established and has solid
  growth potential, consider this investment
  opportunity.
• However, sell your company shares and diversify
  as soon as permitted.
• Failure to do so puts you in double jeopardy You
  are now beholden to your company both for current
  employment and retirement income. If your company
  fails, you lose both. Diversify!

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Practical Element of Personal Finance 9

• Indexed equity funds can help you beat the
  experts without taking excessive risk.

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The Random Walk Theory

• No one person, group of experts, or company can
  predict future changes in the stock market.
• The random walk theory suggests
• Current stock prices reflect all information
  about the company.
• Unforeseeable events drive changes in stock
  prices.
• Since future changes are driven by unforeseen
  events, no one can beat the market.

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Mutual Funds

• Mutual Funds
• A mutual fund pools the savings of many
  individuals and channels them into alternative
  investments.
• There are many types of mutual funds money
  markets, bonds, and equity fund mutual funds.

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Two Types of Equity Funds

• Managed equity funds are administered by
  professionals, seeking to pick and choose stocks.
  A large research staff is often involved.
• Indexed equity funds are invested to reflect the
  holdings of broad indexes such as the Dow Jones
  Industrials, SP 500 Composite Stock Price Index,
  the Russell 2000 Index, or the Wilshire 5000
  Total Market Index.

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Indexed Equity Funds vs. Managed Funds

• Because their holdings simply mirror a broad
  index, indexed equity funds do not require a lot
  of
• Market research
• Stock trading
• Consequently, the administrative costs of indexed
  equity funds are lower than funds managed by
  professionals.
• Thus, more of your funds are channeled into
  investments.
• Historically, the average long-term yield of
  indexed equity funds has been higher than their
  managed counterparts.

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Practical Element of Practical Personal Finance
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• Invest in stocks for long-run objectives
• as the need for money approaches, increase the
  proportion of bonds.

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Hold On

• You have built a diversified portfolio and set
  long-term financial goals.
• You channel savings to cover unexpected
  expenditures.
• Volatile times in financial markets will emerge.
  Ride it out. In the long-run stocks rebound and
  you are covered.
• So avoid selling stocks when the market is
  bearish.

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Stocks vs. Bonds

• Historically, the real return from stocks (about
  7) has been higher than for bonds (about 3).
• The stock market is volatile. Therefore, holding
  stocks is risky when you may need the funds in
  the near future.
• Bonds yield a set nominal return. When funds are
  needed in five years or less, they will be less
  risky than stocks.
• Nonetheless, bonds involve risk.

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Bonds Two Main Types of Risks

• Inflation risk Unexpected inflation erodes the
  purchasing power of the face value of the bond
  and the interest earned.
• Treasury Inflation Protected Securities (TIPS)
  help protect against this risk.
• Interest rate risk Unexpected increases in the
  interest rate reduce the value of outstanding
  bonds.
• This risk increases with the length of time to
  maturity.

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Bond Investment Strategies

• Buy bonds that mature when funds will be needed.
  If you need funds in five years, buy a five year
  bond.
• Transfer funds in a diversified portfolio
  gradually from stocks to bonds as funds will be
  needed in retirement, thus reducing your
  vulnerability to volatile changes in the stock
  market.

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Practical Element of Personal Finance 11

• Beware of investment schemes promising high
  returns with little or no risk.

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Theres no such thing as a free lunch!!!

• Beware of deals that sound too good to be true!
• The principal-agent problem makes you vulnerable.
• A potential conflict of interest exists between
  the investor and the agent selling investment
  products.
• The agent seeks to profit and has more
  information about the product than the investor.
  The investor is at a disadvantage and should be
  skeptical.

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Tips for Avoiding Investment Fraud

• If it looks too good to be true, it probably is.
• Deal only with parties that have a reputation to
  protect.
• Never purchase an investment solicited by
  telephone or email.
• Do not allow yourself to be forced into a quick
  decision.
• Do not allow friendship to influence an
  investment decision.
• If high-pressure marketing is involved, grab your
  checkbook and run!!!

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Practical Element of Personal Finance 12

• Teach your children and others how to earn money
  and spend it wisely.

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Teach Your Children Truths About Money

• Teach children money is earned by providing
  services others valueMoney does not grow on
  trees!
• Money both helps us get what we want, AND helps
  others get what they want.
• Success in general is realized by setting goals
  and working hard to achieve themAchieve
  financial success and security. Start now!