Personal finance

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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]

Contents

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.

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]

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]

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]

As the concerns about consumers' financial capability have increased in recent years, a variety of education programs has emerged, catering to a broad audience or to a specific group of people such as youth and women. The educational programs are frequently known as "financial literacy". However, there was no standardized 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]

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]

Need for Personal Finance

There is a great need for people to understand and take control of their personal finances. These are some of the overarching reasons for it;

1. No formal education for personal finance [9] : Most countries have a formal education across most disciplines or areas of study.

This illustrates the need to learn personal finance from an early stage, [10] in order to differentiate between needs vs. wants [11] and plan accordingly.

2. Shortened employable age: Over the years, with the advent of automation [12] and changing needs; it has been witnessed across the globe that several jobs that require manual intervention, or that are mechanical in nature are increasingly becoming redundant.

These are some of the reasons why individuals should start planning for their retirement and systematically build on their retirement corpus, [16] hence the need for personal finance.

3. Increased life expectancy: [17] With the developments in healthcare, people today are living till a much older age than their forefathers. The average life expectancy have changed over the years and people even in developing economies are living much longer. The average life expectancy has gradually shifted from 60 to 81 [17] and upwards. Increased life expectancy coupled with a shorter employable age reinforces the need of having a large enough retirement corpus and the importance of personal finance.

4. Rising medical expenses: [18] Medical expenses including cost of drugs, hospital admission care and charges, nursing care, specialized care, geriatric care have all seen an exponential rise over the years. Many of these medical expenses are not covered through the insurance policies that might either be private/individual insurance coverage or through federal or national insurance coverage.

These reasons illustrate the need of having medical, accidental, critical illness, life coverage insurance for oneself and ones family as well as the need for emergency corpus; [21] translating the immense need for personal finance.

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: [22]

The limits stated by laws may be different in each country; 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.[ citation needed ]

Areas of focus

Key areas of personal financial planning, as suggested by the Financial Planning Standards Board, are: [23]

  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.
    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.
  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. This is thought to be an important consideration in the creation of personal wealth.
  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. [24] 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. [25] [26] 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. [27]

See also

Related Research Articles

Finance Academic discipline studying businesses and investments

Finance is a term for matters regarding the management, creation, and study of money and investments. Specifically, it deals with the questions of how and why an individual, company or government acquires the money needed – called capital in the company context – and how they spend or invest that money. Finance is then often split per the following major categories: corporate finance, personal finance and public 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 that 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.

Saving income not spent, or deferred consumption

Saving is income not spent, or deferred consumption. Methods of saving include putting money aside in, for example, a deposit account, a pension account, an investment fund, or as cash. Saving also involves reducing expenditures, such as recurring costs. In terms of personal finance, saving generally specifies low-risk preservation of money, as in a deposit account, versus investment, wherein risk is a lot higher; in economics more broadly, it refers to any income not used for immediate consumption. Saving does not automatically include interest.

A registered retirement savings plan (RRSP), or retirement savings plan (RSP), is a type of financial account in Canada for holding savings and investment assets. RRSPs have various tax advantages compared to investing outside of tax-preferred accounts. They were introduced in 1957 to promote savings for retirement by employees and self-employed people.

A 529 plan is a tax-advantaged investment vehicle in the U.S. 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.

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.

A self-directed individual retirement account is an individual retirement account (IRA), provided by some financial institutions in the United States, which allows alternative investments for retirement savings. Some examples of these alternative investments are: real estate, private mortgages, private company stock, oil and gas limited partnerships, precious metals, horses, and intellectual property. The complexity of the rules for self-directed IRA's prompted the SEC to issue a public notice in 2011 against an increased risk of fraud.

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.

A life annuity is an annuity, or series of payments at fixed intervals, paid while the purchaser is alive. A life annuity is an insurance product typically sold or issued by life insurance companies.

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.

A tax-free savings account is an account available in Canada that provides tax benefits for saving. Investment income, including capital gains and dividends, earned in a TFSA is not taxed in most cases, even when withdrawn. Contributions to a TFSA are not deductible for income tax purposes, unlike contributions to a registered retirement savings plan (RRSP).

A non-banking financial institution (NBFI) or non-bank financial company (NBFC) is a financial institution that does not have a full banking license or is not supervised by a national or international banking regulatory agency. NBFI facilitate bank-related financial services, such as investment, risk pooling, contractual savings, and market brokering. Examples of these include insurance firms, pawn shops, cashier's check issuers, check cashing locations, payday lending, currency exchanges, and microloan organizations. Alan Greenspan has identified the role of NBFIs in strengthening an economy, as they provide "multiple alternatives to transform an economy's savings into capital investment which act as backup facilities should the primary form of intermediation fail."

Moshe Arye Milevsky is a Professor of Finance at the Schulich School of Business at York University, Toronto, Canada, where he has been based and teaching for over 25 years. He earned a B.A. in Mathematics and Physics from Yeshiva University in 1990, an M.A. in Mathematics and Statistics from York University in 1992 and a Ph.D in Business Finance from York University in 1996.

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.

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.

Dedicated portfolio theory, in finance, deals with the characteristics and features of a portfolio built to generate a predictable stream of future cash inflows. This is achieved by purchasing bonds and/or other fixed income securities that can and usually are held to maturity to generate this predictable stream from the coupon interest and/or the repayment of the face value of each bond when it matures. The goal is for the stream of cash inflows to exactly match the timing of a predictable stream of cash outflows due to future liabilities. For this reason it is sometimes called cash matching, or liability-driven investing. Determining the least expensive collection of bonds in the right quantities with the right maturities to match the cash flows is an analytical challenge that requires some degree of mathematical sophistication. College level textbooks typically cover the idea of “dedicated portfolios” or “dedicated bond portfolios” in their chapters devoted to the uses of fixed income securities.

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.

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Further reading