Personal Finance: An Integrated Planning Approach

1. Personal Finance:An Integrated Planning Approach Winger and Frasca Chapter 1 Financial Planning: Why It’s Important to You

2. Introduction • Personal financial planning is important because it helps individuals to achieve financial independence. • There is a trend to increased self-reliance. • Many employers are requiring that employees plan and manage their own retirement accounts. Traditional pension plans are less common today. • The federal government is unwilling to deal with the funding problems for Social Security. • There is greater economic uncertainty associated with job stability and investments. Therefore, financial planning is increasingly important.

3. Chapter Objectives • To understand why setting goals is an important first step in financial planning • To appreciate that trends in the financial environment—inflation, taxes, and economic cycles—affect financial success and enhance the need for planning • To see why life-cycle financial planning is important and to understand the nature of a planning approach • To understand what is meant by marginal analysis and opportunity costs and to know how these concepts are used in financial decision making • To appreciate that financial success builds on a strong foundation and follows a building-block approach through time • To meet the Steele family, a family we will follow through the text

4. Topic Outline • Why Study Personal Finance? • Achieving Financial Goals through Planning • Making Financial Decisions • The Building Blocks of Success

5. WHY STUDY PERSONAL FINANCE? • Many people study personal finance in order to achieve financial success. • Financial success may not have the same meaning to everyone. • Some people think financial success is accumulating a lot of money. • Some people may define financial success by their ability to purchase goods and services. • In this textbook, financial success is defined as obtaining the maximum benefits from limited financial resources.

6. Your Goals in Life • Nonfinancial goals • Family, children, education, religious, social, etc. • Finances can affect your ability to attain these goals. • Financial goals • Financial independence is an important goal for many people. Financial independence is defined as having enough income or resources to be self-reliant. • One of the financial choices that we make is between consumption today versus consumption in the future. • Researchers have found that most people, regardless of their income level, feel that they need 20% more wealth than they currently have.

7. The Principle of Diminishing Marginal Satisfaction • Economists suggest that satisfaction from current consumption increases but at a decreasing rate. • Stated simply, people enjoy their current purchases but as they purchase more and more, their satisfaction decreases. • For example, the enjoyment that an individual experiences with the purchase of their first DVD is greater than the enjoyment that the individual experiences upon the purchase of their 100th DVD. • At a certain income level, this explains why individuals are willing to postpone current consumption and save money. • Saving money facilitates the attainment of financial and nonfinancial goals.

8. Important Economic Trends The economic environment affects our ability to achieve our financial goals. • Continuing Inflation • Price levels over the long-run tend to increase 1–3% annually. Inflation must be considered in financial goals. • Persistent Business Cycles • Instability in the economy creates uncertainty that must be considered in financial goals (job stability, emergency reserves, etc.). • Continued Instability in Financial Markets • A High and Selectively Rewarding Tax System • The tax system rewards and punishes certain behaviors. We will review these in greater detail in Chapter 4.

9. ACHIEVING FINANCIAL GOALS THROUGH PLANNING • Planning is the key to achieving all goals especially financial goals. • Life-cycle planning is the phrase that suggests that financial planning is a lifelong process. • People experience different phases in their life such as career development and family formation, retirement, etc. • Major financial planning areas • The different phases of life impact the importance of the various components of financial planning. At different phases, different financial planning areas increase or decrease in importance.

10. Major Financial Planning Areas • Consumption and Savings Planning • Debt Planning • Insurance Planning • Investment Planning • Retirement Planning • Estate Planning • Income Tax Planning • Career Planning

11. Life-Cycle Financial Planning(assumes children/marriage)

12. A Planning Approach Step 1. Determine concrete goals. • First state your broad goal such as the purchase of a home. • Determine the specific pieces to achieve that goal such as the cost of the house, the down payment amount, etc. Step 2. Create an action plan. • How will you achieve the goals stated in step 1? How much will you save each month and where will the money be invested? Step 3. Evaluate performance. • At least annually, evaluate steps 1 and 2 to determine if any adjustments should be made in the action plan or goals. Step 4. Decide on a future course of action. • Is your goal realistic or should it be reevaluated?

13. MAKING FINANCIAL DECISIONS • Decision making is a complex process because there are usually multiple choices with differing attributes. • There are two economic concepts that are helpful in financial decision making. • Marginal Analysis—involves the analysis of the changes in important variables • Example: choosing between a public and private university; the public university costs $15,000 per year whereas the private university costs $40,000 per year. Does the private university provide benefits that compensate for the additional $25,000 ($40,000–$15,000)? • Opportunity Costs—the benefits given up when one alternative is chosen over another • Example: putting money in a savings account rather than investing in the stock market. The opportunity cost is the higher return that could potentially be earned in the stock market.

14. THE BUILDING BLOCKS OF SUCCESS • First, build a supporting foundation. • Give time and attention to building a career, buying adequate insurance, buying a house, and building cash reserves • Then invest in secure investments. • Long-term savings deposits, government securities, and annuities • Gradually take greater risks. • High quality stocks and bonds, real estate • Avoid very risky investments until you are secure at the lower levels. • Growth stocks, gold, undeveloped land

15. What’s a Professional Financial Planner—and Do You Need One? • A financial planner is a professional who helps clients create, maintain, and execute a financial plan. • The best known credentials are the CFP. • Whether or not you need to hire a financial planner depends on the answers to the following questions: • How much time are you willing to spend managing your finances? • How complex is your financial situation? • How much do you know about each of the aspects of financial planning? • Depending on your answers to the questions stated above, you may need to hire a financial planner to assist you with all or part of your financial management.

16. Meet the Steele Family • We will follow a family throughout their decision- making process to illustrate the financial planning process. • They are a typical suburban family consisting of Arnold (h) and Sharon (w) and two children—Nancy and John. • They are enjoying the “good life” associated with an above-average income. • They are currently doing virtually no financial planning. • to educate the children • to enjoy retirement

17. Discussion Questions • What are some of the benefits of personal financial planning? • How do economic cycles affect the personal financial planning process? • What is meant by life-cycle financial planning? • Explain marginal analysis and its importance to financial decision making. • Opportunity cost is a very important concept in financial decision making. Can you think of an example of opportunity cost in your financial planning?

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