Title: Twelve Key Elements of Practical Personal Finance
1Twelve Key Elements of Practical Personal Finance
Common Sense Economics James Gwartney, Richard L.
Stroup, and Dwight R. Lee CommonSenseEconomics.com
2Why Is There Financial Insecurity in America?
- Do You Think It Is Because Incomes Are Low?
- See next slide.
3U.S. Income Is Rising and Has Never Been Higher
4Consumption Per Person Is Also Growing
5Financial Insecurity
- Lets take a look at how households divide their
income between consumption and savings. - Remember, saving helps households prepare for
surprise expenditures.
6U.S. Saving Rates Are Falling While Consumption
Rates Are Rising
7And Interest on Household Debt as a Percentage of
Income
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11Summarizing 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.
12Planning 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.
13Why 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
14If you don't know where you are going, you might
wind up someplace else. Yogi Berra
15Practical Element of Personal Finance 1
- Discover your comparative advantage.
16Comparative 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.
17Farmer John vs. Nurse Kelly Can They Gain From
Specialization and Trade?
18Whats 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?
19Practical 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.
20The 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!
21Entrepreneurs 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.
22Entrepreneurs 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.
23Practical Element of Personal Finance 3
24Why Should You Save?
- Increase your wealth.
- Live a less stressful, more financially free
life. - Achieve high consumption levels in the future.
25How 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.
26Just 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.
27Coffee 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
28Strategic 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.
29Practical Element of Personal Finance 4
- Dont finance anything for
- longer than its useful life.
30Financing 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!
31Good 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).
32What 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.
33Practical Element of Personal Finance 5
- Get More Out of Your Money
- 1. Avoid credit card debt.
- 2. Consider purchasing used items.
34Paint 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.
35Credit 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.
36You 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!
37Buy 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.
38Do 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?
39Do Credit Card Companies Think You Are Suckers?
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- Share points with friends, give points to support
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Karma Points in the Chase 1 store - Why do you think you get so
- many applications?
40Practical Element of Personal Finance 6
- Pay into a real-world savings account every
month.
41Rainy 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.
42Plan 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!
43Practical Element of Personal Finance 7
- Put the power of compound interest to work for
you.
44Its 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!
45The 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)
46Take 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)
47Practical Element of Personal Finance 8
- Diversify - dont put all of your eggs in one
basket.
48Accumulate 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!
49The 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.
50Avoid 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!
51Practical Element of Personal Finance 9
- Indexed equity funds can help you beat the
experts without taking excessive risk.
52The 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.
53Mutual 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.
54Two 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.
55Indexed 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.
56Practical Element of Practical Personal Finance
10
- Invest in stocks for long-run objectives
- as the need for money approaches, increase the
proportion of bonds.
57Hold 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.
58Stocks 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.
59Bonds 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.
60Bond 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.
61Practical Element of Personal Finance 11
- Beware of investment schemes promising high
returns with little or no risk.
62Theres 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.
63Tips 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!!!
64Practical Element of Personal Finance 12
- Teach your children and others how to earn money
and spend it wisely.
65Teach 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!