Twelve Key Elements of Practical Personal Finance: Common Sense Economics

Twelve Key Elements of Practical Personal Finance
Common Sense Economics

James Gwartney, Richard L. Stroup, and Dwight R. Lee CommonSenseEconomics.com
CommonSenseEconomics.com
Why Is There Financial Insecurity in America?
Do You Think It Is Because Incomes Are Low?
See next slide.
U.S. Income Is Rising and Has Never Been Higher

Real Disposable Income Per Capita
35000
30000
Billions of 2000 Chained Dollars
25000
20000
15000
10000
5000
0 1970 1975 1980 1985 1990 1995 2000 2005
Consumption Per Person Is Also Growing

Real Disposible and Consumption Per Capita
30000 25000
Billions of 2000 Chained Dollars
20000
15000
10000
5000
0 1970 1975 1980 1985 1990 Year 1995 2000 2005
CommonSenseEconomics.com Real Personal Disposible Income Per Capita (2000 Dollars) Real Personal Consumption Per Capita (2000 dollars)
Financial Insecurity:
Lets 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
100% 90% 80% 70% 60% 50% 40% 30% 20% 10% 0% 1970
1975
1980
1985
1990
1995
2000
2005
6
Savings Rate
Consumption Rates
And Interest on Household Debt as a Percentage of Income
Real Consumer Credit Outstanding Per Household

22,000 21,000 20,000 19,000 18,000 17,000 16,000 15,000 14,000 13,000 12,000 11,000 10,000 9,000 1970
2007 SA dollars
1975
1980
1985
1990
1995
2000
2005
8
Revolving Debt as a % of Total Consumer Credit

50.00% 45.00% 40.00% 35.00% 30.00% 25.00% 20.00% 15.00% 10.00% 5.00% 0.00% 1970 1975 1980 1985 Year 1990 1995 2000 2005
Percentage
Real Unpaid Credit Card Balance Per U.S. Household (2007 Dollars)
$10,000 $8,000 $6,000 $4,000 $2,000 $0 1970 1975 1980 1985 1990 1995 2000 2005
10
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.
CommonSenseEconomics.com 11
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.
12
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 #1

Discover your comparative advantage.
15
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?
17
Whats 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?
18

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.
19
The Entrepreneur Next Door
Entrepreneurs actively pursue discovering better ways of doing things. They act quickly and strategically on new opportunities. Entrepreneurs fuel economic growth and development!
20
Entrepreneurs Success:
1.
Entrepreneurial talent: the ability to discover

a.
b.
c.
2.
new products that are highly valued relative to costs, cost-reducing production methods, and profitable opportunities that others overlook.
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.
21
Entrepreneurs Success (cont.)

3.
High Savings Rates: Entrepreneurs have high savings rates. Often they invest in their businesses, adding to their wealth. Work Hard and Smart: Entrepreneurs, business owners and independent contractors tend to work longer hours and more strategically.
4.

Spend Less Than You Earn
23
Why Should You Save?

Increase your wealth. Live a less stressful, more financially free life. Achieve high consumption levels in the future.
24
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!!!
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.
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.
b. c.
d.
Nothing. The coffee is consumed! $1,460 $73,000 $ 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.
28

Dont finance anything for longer than its useful life.
29
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. Dont build up debt unless it is strategic!
30
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 Education
Under certain circumstances, these assets generate income and wealth over time. They can help increase your net worth (assets less liabilities).
What Should Not Be Financed?
Nondurables Goods that are consumed or items that lose their value quickly.
Once consumed, food, clothing and concerts are gone. Payments will linger if not paid for when purchased.
32
Get More Out of Your Money 1. Avoid credit card debt. 2. Consider purchasing used items.
33
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.
34
Credit Card Convenience
Paying with a credit card is NOT spending your own money, but borrowing someone elses 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 accountAlways 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? CommonSenseEconomics.com $1300 in interest! And the items costing $2000 are gone!
36
Buy Used When 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?
38
Do Credit Card Companies Think You Are Suckers?

0% Introductory APR on all purchases and balance transfers for up to 6 months No annual fee Earn 15 Karma Points just by getting approved for a Chase credit card Earn more Karma Points at Facebook.com/plus Share points with friends, give points to support causes Get the limited edition Facebook t-shirt with 10 Karma Points Get music, movies, electronics and more with your Karma Points in the Chase +1 store Why do you think you get so many applications?
39
Pay into a real-world savings account every month.

Rainy Days & the Real World
Life is full of surprises, and theyre usually expensive! Cars break down. Heaters and air conditioners go. People get sick or injured.
41
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!
Put the power of compound interest to work for you.

Its 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!
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 - dont put all of your eggs in one basket.
47
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!
48
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.
49
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!
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.
53
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.
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.
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 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.
57
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.

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.
60

Beware of investment schemes promising high returns with little or no risk.
Theres 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.
62
Tips for Avoiding Investment Fraud

1.
2.
3.
4.
5.
6.
If it looks too good to be true, it probably is. Deal only with parties that have a reputation to protect. Never purchase an investment solicited by telephone or email. Do not allow yourself to be forced into a quick decision. Do not allow friendship to influence an investment decision. If high-pressure marketing is involved, grab your checkbook and run!!!
Teach 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 valueMoney 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 themAchieve financial success and security. Start now!

Twelve Key Elements of Practical Personal Finance: Common Sense Economics

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Twelve Key Elements of Practical Personal Finance: Common Sense Economics

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Twelve Key Elements of Practical Personal Finance

Common Sense Economics

Why Is There Financial Insecurity in America?

Do You Think It Is Because Incomes Are Low?

See next slide.

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

Billions of 2000 Chained Dollars

0 1970 1975 1980 1985 1990 1995 2000 2005

Consumption Per Person Is Also Growing

Billions of 2000 Chained Dollars

0 1970 1975 1980 1985 1990 Year 1995 2000 2005

And Interest on Household Debt as a Percentage of Income

Real Consumer Credit Outstanding Per Household

Revolving Debt as a % of Total Consumer Credit

Summarizing Trends in Household Finance

While real income per person is rising,

The savings rate is falling, and Debt is increasing.

Planning to Achieve Financial Security

Why Do We Need or Want Financial Security?

Practical Element of Personal Finance #1

Whats Your Comparative Advantage?

Practical Element of Personal Finance #2

The Entrepreneur Next Door

Entrepreneurial talent: the ability to discover

Entrepreneurs Success (cont.)

Practical Element of Personal Finance #3

Why Should You Save?

How Do You Start?

Nothing. The coffee is consumed! $1,460 $73,000 $ 443,918

Tax deferred savings.

Think of creative ways to spend less.

Practical Element of Personal Finance #4

Good Debt. When can you finance?

Residential home Education

What Should Not Be Financed?

Practical Element of Personal Finance #5

Paint a Bright Future!!!

Credit Card Convenience

You paid how much?

40, 80, 120, or 166 months? 166 months!

How much does the $2000 end up costing you in interest?

Buy Used When Strategic

Do Credit Card Companies Prey on the Financially Illiterate and Undisciplined?

Do Credit Card Companies Think You Are Suckers?

Practical Element of Personal Finance #6

Pay into a real-world savings account every month.

Rainy Days & the Real World

Plan For Your Rainy Days!

Practical Element of Personal Finance #7

Put the power of compound interest to work for you.

Determine how long it takes to double your investment.

70 = Number of years R to double

When R = 7%, your investment will double in?

Take A Closer Look

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.

$8,000 ($4000 + $4000)

$16,000 Age 51? $64,000 ($16,000 + $16,000 + $32,000)

Practical Element of Personal Finance #8

Accumulate Wealth and Gain Financial Security

The Law of Large Numbers

Avoid Double Jeopardy

Practical Element of Personal Finance #9