Transcript
Personal Finance Second Edition Bajtelsmit Chapter 1 The Financial Planning Process ©2020 John Wiley & Sons, Inc. All rights reserved. Chapter 1 Learning Objectives Describe the personal financial planning process, and explain how the elements of a comprehensive financial plan fit together. Describe how individual characteristics and economic factors influence personal financial planning. Create a prioritized list of short-term and long-term personal financial goals. Know when and how to find qualified financial planning professionals. Consider opportunity costs and marginal effects in making personal finance decisions. Learning Objective 1 Describe the personal financial planning process, and explain how the elements of a comprehensive financial plan fit together. L O 1 What Is Personal Financial Planning? Personal financial planning is the process of developing and implementing an integrated, comprehensive plan designed to: Meet financial goals Improve financial well-being Prepare for financial emergencies Personal finance focuses on individual and household financial decisions Budgeting, saving, and spending Tax-planning, insurance, and investments L O 1 What Are the Benefits of Personal Financial Planning? Develop and achieve financial goals Buying a home Making major consumer purchases Supporting a growing family Saving for retirement Social and psychological benefits Less stress Improved relationships Improved self-esteem L O 1 Why Do People Avoid Financial Planning? Why does this happen? They don’t believe their math and finance skills are adequate They fear failure They expect someone else to take care of it They aren’t interested They don’t know whom to trust They are too busy They are overwhelmed with the quantity of information and don’t know where to start L O 1 What Problems Can Be Caused by Poor Financial Planning? What happens to people who don’t manage their finances well or at all? Difficulty in meeting current financial obligations Stress, anxiety, depression, embarrassment Trouble handling financial emergencies Victim of “get rich quick” scams Children may miss high-quality educational opportunities and extracurricular activities without advance financial planning L O 1 The Financial Planning Process: Figure 1.1 L O 1 The Financial Planning Process: Steps 1 and 2 Step 1: Organize Your Financial Information and Set Short-term and Long-term Goals Determine your starting point: Identify where your money is coming from, Identify where it is going, and Collect and organize your financial information Think about why you have these goals Step 2: Analyze Your Current Financial Status Evaluate how well you’re doing Identify areas you need to work on Establish baseline (what you have) to track progress L O 1 The Financial Planning Process: Steps 3, 4, and 5 Step 3: Identify and Evaluate Alternative Strategies for Achieving Your Goals Reduce spending or increase income Identify alternative strategies for achieving each goal Compare the costs and benefits of each strategy Step 4: Implement Your Financial Plan Meet your basic household needs, build wealth over time, and protect your income and assets Step 5: Monitor Your Progress and Revise Your Plan as Needed Life changes affect financial planning objectives and strategies L O 1 Elements of a Comprehensive Financial Plan L O 1 Learning Objective 2 Describe how individual characteristics and economic factors influence personal financial planning. L O 2 Factors That Influence Financial Planning Decisions Individual Characteristics and Your Financial Plan Life cycle factors: income and wealth change over time due to career and family dynamics Demographic characteristics: age, family size, income, and wealth affect expenses Values and attitudes regarding money and its use Values are fundamental beliefs about what is important Attitudes are opinions and psychological differences Risk: take risk or avoid risk? L O 2 Household Income and Wealth over the Life Cycle L O 2 Economic Factors and Your Financial Plan Inflation Increase in price levels over time Affects income, spending, and saving To improve standard of living, growth of income must outpace growth in expenses If the rate of return on your savings is lower than the inflation rate, you are losing purchasing power In the U.S., inflation is measured by the change in the consumer price index (CPI) CPI tracks prices of a representative basket of more than 400 goods and services used by urban households, including food, housing, consumer goods, gasoline, and clothing L O 2 Calculating Percentage Changes To calculate the percentage increase over a period of time, you can use either form of Equation 1.1: To calculate changes over several years, you may want to convert the percentage change to an annual percentage change for the time period, as given in Equation 1.2: L O 2 Example: Calculating Percentage Change Your starting salary in Year 1 was $24,000, and your new salary for Year 3 is $27,500. What is the percentage change in your salary since you started working, and what is the annual percentage change? L O 2 Other Economic Factors Affecting Your Financial Plan Interest rates The cost of borrowing money A measure of your earnings; the return on investment Determined by supply and demand, economic conditions, and the actions of the Federal Reserve The economy and the job market Economic recessions and expansions affect employment and income levels Political unrest and global issues Political uncertainty and global events increase risk L O 2 Inflation, Federal Funds Rate, and 30-Year Mortgage Rates, 1980–2019 L O 2 Learning Objective 3 Create a prioritized list of short-term and long-term personal financial goals. L O 3 Financial Goals Why goals are important Success requires setting goals and making a plan to achieve those goals The goal-setting process Make a prioritized list of specific goals with measurable outcomes Categories include spending, borrowing, education, housing, retirement, vacations, estate planning, and charitable giving Prioritize and determine whether goals are short-term, intermediate-term, or long-term L O 3 SMART Goals Goals should be: Specific Measurable Attainable Realistic, and Time-Specific L O 3 TABLE 1.3 Examples of Goals with Different Time Horizons {69012ECD-51FC-41F1-AA8D-1B2483CD663E}Short-term (less than 1 year): Goal Short-term (less than 1 year): Cost Intermediate-term (1–5 years): Goal Intermediate-term (1–5 years): Cost Long-term (more than 5 years): Goal Long-term (more than 5 years): Cost Vacation $1,000 Pay off credit cards $200/month Comfortable retirement $1,000,000 Increase life insurance $500 Down payment on new car $3,000 Send kids to college $50,000 Eat out once per week $50/week New roof for home $3,000 Remodel the house $30,000 Organize finances – Graduate school $5,000/year Provide for surviving spouse ? Emergency fund $40/week Hire housecleaner $50/week Buy vacation home $50,000 Create budget – Down payment on home $20,000 Leave inheritance for kids ? Make a will $150 Learn about investing – Work on career plan – L O 3 Learning Objective 4 Know when and how to find qualified financial planning professionals. L O 4 Financial Planning Professionals When do you need a financial planner? Comprehensive planning Tax and estate planning are complex and dynamic Factors to consider Education, certification, experience, reputation, and fees How are planners paid? Commissions and/or fees “Fee only” planner charges a set fee for a service or an hourly fee “Commission only” planner receives compensation from selling financial products “Fee plus commission” planner charges a fee for developing your financial plan and also receives commissions on any financial products sold to you L O 4 Learning Objective 5 Consider opportunity costs and marginal effects in making personal finance decisions. L O 5 Making Effective Decisions Base your decisions on reasonable assumptions Avoid excessive optimism Apply marginal reasoning Only consider the marginal, or additional, benefit or cost that will result from the decision you make Consider opportunity costs Measure what you have to give up in order to take a particular action Use sensitivity analysis Evaluate outcomes from different assumptions Consider decision-making styles There are advantages and disadvantage to each type: Avoider vs. Spontaneous; Rational vs. Agonizer L O 5 Sensitivity of Investment Portfolio to Rate-of-Return Assumptions L O 5 Decision-Making Styles TABLE 1.6 Decision-Making Styles {69012ECD-51FC-41F1-AA8D-1B2483CD663E}Type of Decision Maker Common Characteristics Rational decision maker Uses a systematic approach to making decisions Weighs the pros and cons, often making careful lists for comparison Intuitive decision maker Spontaneous Often makes “gut” decisions External decision maker Obtains opinions and confirmation from others before making decisions Has trouble making decisions independently Agonizer Puts off making decisions as long as possible Spends a lot of time thinking over alternatives, even for relatively inconsequential decisions Is uncomfortable with change Avoiders Can’t or won’t make decisions Delegates decision to others or ignores the problem, hoping it will go away L O 5 Copyright ©2020 John Wiley & Sons, Inc. All rights reserved. No part of this publication may be reproduced, stored in a retrieval system, or transmitted, in any form or by any means, electronic, mechanical, photocopying, recording or otherwise, except as permitted by law. Advice on how to obtain permission to reuse this material is available at http://www.wiley.com/go/permissions.
