Personal finance

Last updated

Personal finance is the financial management which an individual or a family unit performs to budget, save, and spend monetary resources over time, taking into account various financial risks and future life events. [1] When planning personal finances, the individual would consider the suitability to his or her needs of a range of banking products (checking, savings accounts, credit cards and consumer loans) or investment private equity, (stock market, bonds, mutual funds) and insurance (life insurance, health insurance, disability insurance) products or participation and monitoring of and- or employer-sponsored retirement plans, social security benefits, and income tax management.

Financial management focuses on ratios, equities and debts. It is useful for portfolio management,distribution of dividend,capital raising,hedging and looking after fluctuations in foreign currency and product cycles.Financial managers are the people who will do research and based on the research, decide what sort of capital to obtain in order to fund the company's assets as well as maximizing the value of the firm for all the stakeholders. It also refers to the efficient and effective management of money (funds) in such a manner as to accomplish the objectives of the organization. It is the specialized function directly associated with the top management. The significance of this function is not seen in the 'Line' but also in the capacity of the 'Staff' in overall of a company. It has been defined differently by different experts in the field.

Personal budget finance plan that allocates future personal income towards expenses, savings and debt repayment

A personal budget or home budget is a finance plan that allocates future personal income towards expenses, savings and debt repayment. Past spending and personal debt are considered when creating a personal budget. There are several methods and tools available for creating, using and adjusting a personal budget. For example, jobs are an income source, while bills and rent payments are expenses.

Savings account type of account maintained by retail financial institutions

A savings account is a deposit account held at a retail bank that pays interest but cannot be used directly as money in the narrow sense of a medium of exchange. These accounts let customers set aside a portion of their liquid assets while earning a monetary return.

Contents

History

Before a specialty in personal finance was developed, various disciplines which are closely related to it, such as family economics, and consumer economics were taught in various colleges as part of home economics for over 100 years. The earliest known research in personal finance was done in 1920 by Hazel Kyrk. Her dissertation at University of Chicago laid the foundation of consumer economics and family economics. [2] Margaret Reid, a professor of Home Economics at the same university, is recognized as one of the pioneers in the study of consumer behavior and Household behavior. [2] [3]

Family economics applies economic concepts such as production, division of labor, distribution, and decision making to the study of the family. It tries to explain outcomes unique to family—such as marriage, the decision to have children, fertility, polygamy, time devoted to domestic production, and dowry payments using economic analysis.

Consumer economics is a branch of economics. It is a broad field, principally concerned with microeconomic analysis behavior in units of consumers, families, or individuals. It sometimes also encompasses family financial planning and policy analysis. The term largely describes what was more commonly called "home economics" in the past.

Home economics

Home economics, domestic science or home science is a field of study that deals with the relationship between individuals, families, communities, and the environment in which they live. Home economics courses are offered internationally and across multiple educational levels. Home economics courses have been important throughout history because it gave women the opportunity to pursue higher education and vocational training in a world where only men were able to learn in such environments. In modern times, home economics teaches both men and women important life skills, such as cooking, sewing, and finances. With the stigma the term “home economics” has earned over the years, the course is now often referred to by different terms, such as “family and consumer science.”

In 1947, Herbert A. Simon, a Nobel laureate, suggested that a decision maker did not always make the best financial decision because of limited educational resources and personal inclinations. [2] In 2009, Dan Ariely suggested the 2008 financial crisis showed that human beings do not always make rational financial decisions, and the market is not necessarily self-regulating and corrective of any imbalances in the economy. [2] [4]

Herbert A. Simon American political scientist, economist, sociologist, and psychologist

Herbert Alexander Simon was an American economist, political scientist and cognitive psychologist, whose primary research interest was decision-making within organizations and is best known for the theories of "bounded rationality" and "satisficing". He received the Nobel Prize in Economics in 1978 and the Turing Award in 1975. His research was noted for its interdisciplinary nature and spanned across the fields of cognitive science, computer science, public administration, management, and political science. He was at Carnegie Mellon University for most of his career, from 1949 to 2001.

Dan Ariely Israeli American professor of psychology and behavioral economics

Dan Ariely is an Israeli James B. Duke Professor of Psychology and Behavioral Economics at Duke University and is the founder of The Center for Advanced Hindsight and co-founder of Kayma BEworks, Timeful, Genie and Shapa. Ariely is also associated with Qapital and Lemonade in the capacity of Chief Behavioral Economist and Chief Behavioral Officer, respectively. Ariely's TED talks have been viewed over 10 million times. He is the author of Dollars and Sense, Predictably Irrational, The Upside of Irrationality, and The Honest Truth about Dishonesty. All three books became New York Times best sellers. He also wrote two semi-books: Irrationally Yours – an illustrated collection of his immensely popular The Wall Street Journal advice column, “Ask Ariely” – and Payoff, a short TED book. Ariely was involved in the movie (Dis)Honesty: The Truth About Lies as both a producer and a participant.

Therefore, personal finance education is needed to help an individual or a family make rational financial decisions throughout their life. Before 1990, mainstream economists and business faculty paid little attention to personal finance. However, several American universities such as Brigham Young University, Iowa State University, and San Francisco State University have started to offer financial educational programmes in both undergraduate and graduate programmes in the last 30 years. These institutions have published several works in journals such as The Journal of Financial Counseling and Planning and the Journal of Personal Finance. Research into personal finance is based on several theories such as social exchange theory and andragogy (adult learning theory). Professional bodies such as American Association of Family and Consumer Sciences and American Council on Consumer Interests started to play an important role in the development of this field from the 1950s to 1970s. The establishment of the Association for Financial Counseling and Planning Education (AFCPE) in 1984 at Iowa State University and the Academy of Financial Services (AFS) in 1985 marked an important milestone in personal finance history. Attendances of the two societies mainly come from faculty and graduates from business and home economics colleges. AFCPE has since offered several certifications for professionals in this field such as Accredited Financial Counselor (AFC) and Certified Housing Counselors (CHC). Meanwhile, AFS cooperates with Certified Financial Planner (CFP Board). [2]

Brigham Young University private research university located in Provo, Utah, United States

Brigham Young University is a private, non-profit research university in Provo, Utah, United States owned by The Church of Jesus Christ of Latter-day Saints and run under the auspices of its Church Educational System. The university is classified among "Doctoral Universities: High Research Activity" with "more selective, lower transfer-in" admissions. The university's primary emphasis is on undergraduate education in 179 majors, but it also has 62 master's and 26 doctoral degree programs. The university also administers two satellite campuses, one in Jerusalem and one in Salt Lake City, while its parent organization, the Church Educational System (CES), sponsors sister schools in Hawaii and Idaho.

Iowa State University public research university in Ames, Iowa, United States

Iowa State University of Science and Technology, generally referred to as Iowa State, is a public land-grant and space-grant research university located in Ames, Iowa, United States. It is the largest university in the state of Iowa and the third largest university in the Big 12 athletic conference. Iowa State is classified as a research university with "highest research activity" by the Carnegie Foundation for the Advancement of Teaching. Iowa State is also a member of the Association of American Universities (AAU), which consists of 60 leading research universities in North America.

San Francisco State University university in San Francisco, California

San Francisco State University is a public university in San Francisco. As part of the 23-campus California State University system, the university offers 118 different bachelor's degrees, 94 master's degrees, and 5 doctoral degrees along with 26 teaching credentials among six academic colleges.

As the concerns about consumers' financial capability have increased in recent years, a variety of education programmes has emerged, catering to a broad audience or to a specific group of people such as youth and women. The educational programmes are frequently known as "financial literacy". However, there was no standardised curriculum for personal finance education until after the 2008 financial crisis. The United States President’s Advisory Council on Financial Capability was set up in 2008 in order to encourage financial literacy among the American people. It also stressed the importance of developing a standard in the field of financial education. [2]

Financial literacy is the possession of the set of skills and knowledge that allows an individual to make informed and effective decisions with all of their financial resources. Raising interest in personal finance is now a focus of state-run programs in countries including Australia, Canada, Japan, the United States and the United Kingdom. Understanding basic financial concepts allows people to know how to navigate in the financial system. People with appropriate financial literacy training make better financial decisions and manage money better that those without such training.

Personal financial planning process

The key component of personal finance is financial planning, which is a dynamic process that requires regular monitoring and re-evaluation. In general, it involves five steps: [5] [6]

  1. Assessment: A person's financial situation is assessed by compiling simplified versions of financial statements including balance sheets and income statements. A personal balance sheet lists the values of personal assets (e.g., car, house, clothes, stocks, bank account), along with personal liabilities (e.g., credit card debt, bank loan, mortgage). A personal income statement lists personal income and expenses.
  2. Goal setting: Having multiple goals is common, including a mix of short- and long-term goals. For example, a long-term goal would be to "retire at age 65 with a personal net worth of $1,000,000," while a short-term goal would be to "save up for a new computer in the next month." Setting financial goals helps to direct financial planning. Goal setting is done with an objective to meet specific financial requirements.
  3. Plan creation: The financial plan details how to accomplish the goals. It could include, for example, reducing unnecessary expenses, increasing the employment income, or investing in the stock market.
  4. Execution: Execution of a financial plan often requires discipline and perseverance. Many people obtain assistance from professionals such as accountants, financial planners, investment advisers, and lawyers.
  5. Monitoring and reassessment: As time passes, the financial plan is monitored for possible adjustments or reassessments.

Typical goals that most adults and young adults have are paying off credit card/student loan/housing/car loan debt, investing for retirement, investing for college costs for children, paying medical expenses. [7] [8]

Personal finance principles

Personal circumstances differ considerably, with respect to patterns of income, wealth, and consumption needs. Tax and finance laws also differ from country to country, and market conditions vary geographically and over time. This means that advice appropriate for one person might not be appropriate for another. A financial advisor can offer personalized advice in complicated situations and for high-wealth individuals, but University of Chicago professor Harold Pollack and personal finance writer Helaine Olen argue that in the United States good personal finance advice boils down to a few simple points: [9]

The limits stated by laws may be different in each countries; in any case personal finance should not disregard correct behavioral principles: people should not develop attachment to the idea of money, morally reprehensible, and, when investing, should maintain the medium-long term horizon avoiding hazards in the expected return of investment.

Areas of focus

Key areas of personal financial planning, as suggested by the Financial Planning Standards Board, are: [10]

  1. Financial position: is concerned with understanding the personal resources available by examining net worth and household cash flow. Net worth is a person's balance sheet, calculated by adding up all assets under that person's control, minus all liabilities of the household, at one point in time. Household cash flow totals up all the expected sources of income within a year, minus all expected expenses within the same year. From this analysis, the financial planner can determine to what degree and in what time the personal goals can be accomplished.
  2. Adequate protection: or insurance, the analysis of how to protect a household from unforeseen risks. These risks can be divided into liability, property, death, disability, health and long-term care. Some of these risks may be self-insurable while most will require the purchase of an insurance contract. Determining how much insurance to get, at the most cost effective terms requires knowledge of the market for personal insurance. Business owners, professionals, athletes and entertainers require specialized insurance professionals to adequately protect themselves. Since insurance also enjoys some tax benefits, utilizing insurance investment products may be a critical piece of the overall investment planning.
  3. Tax planning: typically, the income tax is the single largest expense in a household. Managing taxes is not a question whether or not taxes will be paid, but when and how much. The government gives many incentives in the form of tax deductions and credits, which can be used to reduce the lifetime tax burden. Most modern governments use a progressive tax. Typically, as one's income grows, a higher marginal rate of tax must be paid. Understanding how to take advantage of the myriad tax breaks when planning one's personal finances can make a significant impact.
  4. Investment and accumulation goals: planning how to accumulate enough money for large purchases and life events is what most people consider to be financial planning. Major reasons to accumulate assets include, purchasing a house or car, starting a business, paying for education expenses, and saving for retirement.
    Achieving these goals requires projecting what they will cost, and when one needs to withdraw funds. A major risk to the household in achieving their accumulation goal is the rate of price increases over time, or inflation. Using net present value calculators, the financial planner will suggest a combination of asset earmarking and regular savings to be invested in a variety of investments. In order to overcome the rate of inflation, the investment portfolio has to get a higher rate of return, which typically will subject the portfolio to a number of risks. Managing these portfolio risks is most often accomplished using asset allocation, which seeks to diversify investment risk and opportunity. This asset allocation will prescribe a percentage allocation to be invested in stocks, bonds, cash and alternative investments. The allocation should also take into consideration the personal risk profile of every investor, since risk attitudes vary from person to person.
  5. Retirement planning is the process of understanding how much it costs to live at retirement, and coming up with a plan to distribute assets to meet any income shortfall. Methods for retirement plan include taking advantage of government allowed structures to manage tax liability including: individual (IRA) structures, or employer sponsored retirement plans.
  6. Estate planning involves planning for the disposition of one's assets after death. Typically, there is a tax due to the state or federal government when one dies. Avoiding these taxes means that more of one's assets will be distributed to their heirs. One can leave their assets to family, friends or charitable groups.
  7. Delayed gratification: Delayed gratification, or deferred gratification is the ability to resist the temptation for an immediate reward and wait for a later reward. For creation of personal wealth this is one of the key. .
  8. Cash Management: It is the soul of your financial planning, whether you are an employee or planning your retirement. It is a must for every financial planner to know how much he/she spends prior to his/her retirement so that he/she can save a significant amount. This analysis is a wake-up call as many of us are aware of our income but very few actually track their expenses.
  9. Revisiting Written Financial Plan Regularly: Make it a habit to monitor your financial plan regularly. An annual review of your financial planning with a professional keeps you well-positioned, and informed about the required changes, if any, in your needs or life circumstances. You should be well- prepared for all sudden curve balls that life inevitably throws in your way.
  10. Education Planning: With the growing interests on students’ loan, having a proper financial plan in place is crucial. Parents often want to save for their kids but end up taking the wrong decisions, which affect the savings adversely. We often observe that, many parents give their kids expensive gifts, or unintentionally endanger the opportunity to obtain the much-needed grant. Instead, one should make their kids prepare for the future and support them financially in their education.

Education and tools

An example of personal budget planning software Budgetplanatm.JPG
An example of personal budget planning software

According to a survey done by Harris Interactive, 99% of the adults agreed that personal finance should be taught in schools. [11] Financial authorities and the American federal government had offered free educational materials online to the public. However, according to a Bank of America poll, 42% of adults were discouraged while 28% of adults thought that personal finance is a difficult subject because of vast amount of information available online. As of 2015, 17 out of 50 states in the United States requires high school students to study personal finance before graduation. [12] [13] The effectiveness of financial education on general audience is controversial. For example, a study done by Bell, Gorin and Hogarth (2009) stated that those who undergo financial education were more likely to use a formal spending plan. Financially educated high school students are more likely to have a savings account with regular savings, fewer overdrafts and more likely to pay off their credit card balances. However, another study was done by Cole and Shastry (Harvard Business School, 2009) found that there were no differences in saving behaviours of people in American states with financial literacy mandate enforced and the states without a literacy mandate. [2]

Kiplinger publishes magazines on personal finance. [14]

Depreciating assets

One thing to consider with personal finance and net worth goals is depreciating assets. A depreciating asset is an asset that loses value over time or with use. A few examples would be the vehicle that a person owns, boats, and capitalized expenses. They add value to a person's life but unlike other assets they do not make money and should be a class of their own. In the business world, for tax and bookkeeping purposes, these are depreciated over time due to the fact that their useful life runs out. This is known as accumulated depreciation and the asset will eventually need to be replaced.

See also

Related Research Articles

Finance Academic discipline studying businesses and investments

Finance is a field that is concerned with the allocation (investment) of assets and liabilities over space and time, often under conditions of risk or uncertainty. Finance can also be defined as the art of money management. Participants in the market aim to price assets based on their risk level, fundamental value, and their expected rate of return. Finance can be split into three sub-categories: public finance, corporate finance and personal finance.

A pension is a fund into which a sum of money is added during an employee's employment years, and from which payments are drawn to support the person's retirement from work in the form of periodic payments. A pension may be a "defined benefit plan" where a fixed sum is paid regularly to a person, or a "defined contribution plan" under which a fixed sum is invested and then becomes available at retirement age. Pensions should not be confused with severance pay; the former is usually paid in regular installments for life after retirement, while the latter is typically paid as a fixed amount after involuntary termination of employment prior to retirement.

A 529 plan is a tax-advantaged investment vehicle in the United States of America designed to encourage saving for the future higher education expenses of a designated beneficiary. In 2017, K-12 public, private, and religious school tuition were included as qualified expenses for 529 plans along with post-secondary education costs with passage of the Tax Cuts and Jobs Act.

A health savings account (HSA) is a tax-advantaged medical savings account available to taxpayers in the United States who are enrolled in a high-deductible health plan (HDHP). The funds contributed to an account are not subject to federal income tax at the time of deposit. Unlike a flexible spending account (FSA), HSA funds roll over and accumulate year to year if they are not spent. HSAs are owned by the individual, which differentiates them from company-owned Health Reimbursement Arrangements (HRA) that are an alternate tax-deductible source of funds paired with either high-deductible health plans or standard health plans.

Tax advantage refers to the economic bonus which applies to certain accounts or investments that are, by statute, tax-reduced, tax-deferred, or tax-free. Governments establish the tax advantages to encourage private individuals to contribute money when it is considered to be in the public interest.

Financial planner profession

A financial planner or personal financial planner is a professional who prepares financial plans for people. These financial plans often cover cash flow management, retirement planning, investment planning, financial risk management, insurance planning, tax planning, estate planning and business succession planning.

The Certified Financial Planner (CFP) designation is a professional certification mark for financial planners conferred by the Certified Financial Planner Board of Standards in the United States, and by 25 other organizations affiliated with Financial Planning Standards Board (FPSB), the international owner of the CFP mark outside of the United States.

Capital formation Increasing the stock of real capital in the country

Capital formation is a concept used in macroeconomics, national accounts and financial economics. Occasionally it is also used in corporate accounts. It can be defined in three ways:

A private pension is a plan into which individuals contribute from their earnings, which then will pay them a private pension after retirement. It is an alternative to the state pension. Usually individuals invest funds into saving schemes or mutual funds, run by insurance companies. Often private pensions are also run by the employer and are called occupational pensions. The contributions into private pension schemes are usually tax-deductible. This is similar to the regular pension.

The following outline is provided as an overview of and topical guide to finance:

The financial management advisor (FMA) is a professional designation of the Canadian Securities Institute (CSI), the official educator of the Canadian securities industry. The FMA is a personal financial planning designation which is usually a precursor to the certified financial planner (CFP) designation. There are over three thousand FMA holders in Canada. The FMA designation is not recognized in the province of Quebec.

Retirement planning, in a financial context, refers to the allocation of savings or revenue for retirement. The goal of retirement planning is to achieve financial independence.

Asset location (AL) is a term used in personal finance to refer to how investors distribute their investments across savings vehicles including taxable accounts, tax-exempt accounts, tax-deferred accounts, trust accounts, variable life insurance policies, foundations, and onshore vs. offshore accounts.

Retirement spend-down

At retirement, individuals stop working and no longer get employment earnings, and enter a phase of their lives, where they rely on the assets they have accumulated, to supply money for their spending needs for the rest of their lives. Retirement spend-down, or withdrawal rate, is the strategy a retiree follows to spend, decumulate or withdraw assets during retirement.

Goal Based Investing or Goal Driven Investing is an investment methodology where performance is measured by the success of investments in meeting an individual's personal and lifestyle goals. This differs from conventional investing methodologies, where financial performance is defined as a return against an investment benchmark. This approach results in focus of the investment approach shifting from achieving a higher returns approach to the investment, or exceeding the market returns approach to funding a personal financial goals approach.

The Institute of Business and Finance (IBF) is a financial training institute providing online financial and educational materials, certification programs and support to the financial community and general public.

Property investment calculator is a term used to define an application that provides fundamental financial analysis underpinning the purchase, ownership, management, rental and/or sale of real estate for profit. Property Investment Calculators are typically driven by mathematical finance models and converted into source code. Key concepts that drive property investment calculators include returns, cash flow, affordability of financing, investment strategy, equity and risk management.

References

  1. "Personal Finance". Investopedia. Retrieved 7 April 2012.
  2. 1 2 3 4 5 6 7 Tahira, K. Hira (1 December 2009). "Personal finance: Past, present, and future". Social Science Research Network. Iowa State University - Department of Human Development and Family Studies: 4–16. SSRN   1522299 .
  3. "Guide to the Margaret G. Reid Papers 1904-1990". The University of Chicago Library. 2010. Archived from the original on 3 July 2013. Retrieved 28 September 2015.
  4. Ariely, Dan (July 2009). "The End of Rational Economics". Harvard Business Review . Retrieved 28 September 2015.
  5. "What is Personal Finance?". Practical Financial Tips. Retrieved 7 April 2012.
  6. "Creating a Personal Financial Plan" (PDF). Missouri State University. Archived from the original (PDF) on 17 September 2015. Retrieved 28 September 2015.
  7. "Goals:Setting financial goals". CNN. Archived from the original on 28 September 2015. Retrieved 28 September 2015.
  8. "Financial Planning And Goal Setting". The USAA (United Services Automobile Association) Educational Foundation. Archived from the original on 28 September 2015. Retrieved 28 September 2015.
  9. Can The Best Financial Tips Fit On An Index Card?
  10. "Financial Planning Curriculum Framework". Financial Planning Standards Board. 2011. Archived from the original on 1 February 2012. Retrieved 7 April 2012.
  11. Kadlec, Dan (10 October 2013). "Why We Want—But Can't Have—Personal Finance in Schools". Time. Retrieved 24 October 2015.
  12. Antonia, Farzan (2 May 2015). "High schools are beginning to require personal finance courses. Finally". Business Insider . Archived from the original on 28 September 2015. Retrieved 28 September 2015.
  13. "Survey of the States". Council for Economic Education. Archived from the original on 13 August 2015. Retrieved 28 September 2015.
  14. "10 Best Personal-Finance Tools to Better Manage Your Money". Kiplinger. Archived from the original on 5 September 2015. Retrieved 28 September 2015.

Further reading