Personal finance.hs

Twelve Key Elements Twelve Key Elements of Practical Personal of Practical Personal

FinanceFinance

CommonSenseEconomics.com 1

Common Sense Economics

James Gwartney, Richard L. Stroup, Dwight R. Lee, and Tawni H. Ferrarini

CommonSenseEconomics.com

Twelve Key Elements of Practical Personal Finance

1) Discover your comparative advantage.2) Be entrepreneurial. In a market

economy, people get ahead by helping others and discovering better ways of doing things

3) Use budgeting to help you save regularly and spend your money more effectively.

4) Don’t finance anything for longer than its useful life.



5) Two ways to get more out of your money: Avoid credit-card debt and consider purchasing used items.

6) Begin paying into a “real-world” savings account every month.

7) Put the power of compound interest to work for you.

8) Diversify-don’t put all of your eggs in one basket.



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

10)Invest in stocks for long-run objectives, but as the need or money approaches, increase the proportion of bonds.

11)Beware of investment schemes promising high returns with little or not risk.

12)Teach your children how to earn money and spend it wisely.


Where do we begin??

• To begin this session, I would like each of you to complete the “Personal Finance IQ Quiz!”– You will find the document posted

under course resources for this week.– I will post the answers to the quiz at

the end of the week!!


Why Is There Financial Insecurity in America?

• Do You Think It Is

Because Incomes Are Low?– Not Really, see the next

slide!!!


U.S. Income Is Rising and Has Never Been Higher


Real Disposable Income Per Capita

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35000

1970 1975 1980 1985 1990 1995 2000 2005

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Consumption Per Person Is Also Growing

Real Disposible and Consumption Per Capita

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Real Personal Disposible Income Per Capita (2000 Dollars) Real Personal Consumption Per Capita (2000 dollars)


Financial Insecurity:

• Let’s take a look at how households divide their income between consumption and savings.

• Remember, saving helps households prepare for surprise expenditures.


U.S. Saving Rates Are Falling While Consumption Rates Are Rising …


As a Percentage of Real Disposable Income

0%

10%

20%

30%

40%

50%

60%

70%

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100%

1970 1975 1980 1985 1990 1995 2000 2005

Savings Rate Consumption Rates


Real Consumer Credit Outstanding Per Household

9,000

10,00011,000

12,00013,000

14,00015,000

16,00017,000

18,00019,000

20,00021,000

22,000

1970 1975 1980 1985 1990 1995 2000 2005

2007

SA

dol

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Revolving Debt as a % of Total Consumer Credit

0.00%

5.00%

10.00%

15.00%

20.00%

25.00%

30.00%

35.00%

40.00%

45.00%

50.00%

1970 1975 1980 1985 1990 1995 2000 2005

Year

Perc

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Real Unpaid Credit Card Balance Per U.S. Household (2007 Dollars)

$0

$2,000

$4,000

$6,000

$8,000

$10,000

1970 1975 1980 1985 1990 1995 2000 2005

Why do we need money, when we have credit cards?• A little videos on credit

card debt


How much debt do we have in America?


A Student’s Story:


And Interest on Household Debt as a Percentage of Income


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.


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.


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


“If you don't know where you are going, you might wind up

someplace else.”

~ Yogi Berra


Practical Element of Personal Finance #1Discover your comparative

advantage.


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.


Farmer John vs. Nurse Kelly: Can They Gain From

Specialization and Trade?


What’s 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?


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.


The Entrepreneur Next The Entrepreneur Next DoorDoor

• Entrepreneurs actively pursue discovering better ways of doing things.

• They act quickly and strategically on new opportunities.


Entrepreneurial Fuel


Entrepreneurs’ Success:

1. Entrepreneurial talent: : the ability to discover

a. new products that are highly valued relative to costs,

b. cost-reducing production methods, and

c. profitable opportunities that others overlook.


Entrepreneurs’ Success:

2. 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.


Entrepreneurs’ Success (cont.)3. High Savings Rates:

Entrepreneurs have high savings rates. Often they invest in their businesses, adding to their wealth.


Entrepreneurs’ Success (cont.)4. Work Hard and Smart:

Entrepreneurs, business owners and independent contractors tend to work longer hours and more strategically.


#2 Be EntrepreneurialKen Olson, chairman/founder of Digital

Equipment Corp., 1977: "There is no reason anyone would want a computer in their home."

Fred Smith’s (FedEx) Yale University Senior Project Grade Remark: "The concept is interesting and well-formed, but in order to earn better than a 'C,' the idea must be feasible."

33


Spend Less Than You Earn


Why Should You Save?

• Increase your wealth.

• Live a less stressful, more financially free life.

• Achieve high consumption levels in the future.


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.


Just Do It!!!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. CommonSenseEconomics.com 37

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?

a. Nothing. The coffee is consumed!

b. $1,460c. $73,000d. $ 443,918


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.

39

Practical Element of Personal Finance #4Don’t finance anything for

longer than its useful life.


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. Don’t build up debt unless it is strategic! CommonSenseEconomics.com 41

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 – Automobiles (in some cases)– Education

Under certain circumstances, these assets generate income and wealth over time. They can help increase your net worth (assets less liabilities). CommonSenseEconomics.com 42

What Should Not Be Financed?

• Nondurables – Goods that are consumed or items that lose their value quickly. – Food

– Clothing

– Entertainment

– Vacations43


Get More Out of Your Money


How???

• Two ways:– Avoid credit card debt– Consider purchasing

used items


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.”

Credit Card Convenience

• Paying with a credit card is NOT spending your own money, but borrowing someone else’s 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 account…Always pay your credit card bill in full.


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!


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.


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?CommonSenseEconomics.com 50

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• Why do you think you get somany applications?

51


Pay into a “real-world” savings account every

month.CommonSenseEconomics.com 52

Rainy Days and the Real World

• Life is full of “surprises”, and they’re usually expensive!• Cars break down.• Heaters and air

conditioners go.• People get sick or

injured.CommonSenseEconomics.com 53

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! CommonSenseEconomics.com 54


Put the power of compound

interest to work for you.


It’s a Miracle!!!It’s 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! 56

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)


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)



Diversify - don’t put all of your eggs in one basket.


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!


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.


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!

62


Indexed equity funds can help you beat the experts without taking

excessive risk.


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”.


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.


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, S&P 500 Composite Stock Price Index, the Russell 2000 Index, or the Wilshire 5000 Total Market Index.

66

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. 67

Practical Element of Practical

Personal Finance #10

Invest in stocks for long-run objectives;

as the need for money approaches, increase the proportion of bonds.


Hold OnHold 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”. 69

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.


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. CommonSenseEconomics.com 71

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.



Beware of investment schemes promising high returns with little or no

risk.


There’s 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.

CommonSenseEconomics.com74

Tips for Avoiding Investment Fraud

1. If it looks too good to be true, it probably is.2. Deal only with parties that have a reputation

to protect.3. Never purchase an investment solicited by

telephone or email.4. Do not allow yourself to be forced into a quick

decision.5. Do not allow friendship to influence an

investment decision.6. If high-pressure marketing is involved, grab

your checkbook and run!!!75

Practical Element of Personal

Finance #12Teach your children and

others how to earn money and spend it

wisely.


Teach Your Children Truths About Money

• Teach children money is earned by providing services others’ value…Money 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 them…Achieve financial success and security. Start now!

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78

Review

• Understand the causes of the financial insecurity in America

• Know how to effectively budget your money and the importance of saving now for your future.

• Know the 12 Key Elements of Personal Finance:1. Discover your comparative advantage2. Be entrepreneurial3. Spend less than you earn (Save Now!)

79

Review

Know the 12 Key Elements of Personal Finance (continued):

4. Don’t finance anything for longer than its useful life.

5. Get more out of your money (avoid credit card debt and buy used)

6. Establish a real-world savings account7. Harness the power of compound interest8. Diversify9. Indexed equity funds can help you beat the

market10. Invest in stocks for the long run and bonds

for the short run11. Beware of investment schemes promising

high returns and little to no risk12. Teach your children about money (earning

and saving)

Personal finance.hs

Economy & Finance

personal finance iq

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real disposible

higher real disposable

real unpaid credit c

money approaches

creditcard debt