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Twelve Key Elements of Practical Personal Finance

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1 Twelve Key Elements of Practical Personal Finance
Common Sense Economics James Gwartney, Richard L. Stroup, and Dwight R. Lee

2 A Personal Financial Epidemic?
Why do Americans live under so much financial stress when their incomes are higher than ever? Financial insecurity is the result of the choices we make rather than the income we earn. The principles that lead to financial security are largely the same as the ones underlying a prosperous economy. Financial stress is likely to be/have been an issue in all your students’ lives. It may be useful to lead off a discussion by asking students to relate their own financial worries, but it is also likely that many students will be reticent about sharing such information, at least initially.

3 Who Needs Money? There is more to a good life than making money!!!
But the desire for more wealth unseemly!!! Our life objectives are easier to achieve if we have more wealth. Point out to students that neither is economics all about money, nor is the successful pursuit of wealth the key to personal happiness. However, such endeavors of late seem to have attracted just such a reputation. Emphasize to students that it is not at all immoral or unethical to desire and strive to make money. Instead, focus on the successful pursuit of wealth as the key to helping others.

4 Discover your comparative advantage.
Practical Element #1 Discover your comparative advantage.

5 Comparative Advantage
We are all relatively more productive in some areas than in others. Your comparative advantage is determined by your comparative abilities, not your absolute abilities. A common example used to illustrate comparative advantage is that of the golfer and the caddy. While the golfer may in fact be better at both golfing AND caddying (i.e., he has the absolute advantage in both activities), he is relatively better at golf. This means that he sacrifices less when he focuses, or specializes in golfing than does the caddy. The golfer is a much better golfer than caddy, while the difference between the caddy’s skills is less pronounced. If the caddy continues to specialize in caddying, he sacrifices less in terms of gains from golf than the golfer would if he chose to caddy.

6 What’s Your Comparative Advantage?
Even if you’re better at doing everything, you shouldn’t. Specialize in what you are relatively the best at…for which you give up the least. Allow others’ work to be to your advantage. Self-sufficiency is for novels, not real life!

7 Practical Element #2 Be entrepreneurial. In a market economy, people get ahead by helping others and discovering better ways of doing things. Students often think of entrepreneurs strictly as individuals who start their own businesses. While these people are in fact entrepreneurs, the message to be conveyed here is that while not everyone will ultimately go into business for themselves, We can all learn to think and act more entrepreneurially, and to great effect in our personal financial lives.

8 Who are Entrepreneurs? People adept at discovering better ways of doing things and acting on these opportunities. Disproportionately wealthy… 2/3 of American millionaires are entrepreneurs. It is a common misconception that the wealthiest of Americans either inherited their wealth and/or work for major companies. In fact, approximately 80% of American millionaires instead consider themselves to be entrepreneurs.

9 Entrepreneurs’ Success:
Entrepreneurial talent: the ability to discover innovative new products, cost-reducing production methods, and profitable opportunities that have been overlooked by others. Tolerance for risk: Self-employment is more risky, but greater risk and higher returns go together.

10 Entrepreneurs’ Success (cont.)
High Savings Rates: Investing in their businesses adds to entrepreneurs’ wealth. Hard Work …Business owners tend to work longer hours.

11 Spend less than you earn. Begin a regular savings program now.
Practical Element #3 Spend less than you earn. Begin a regular savings program now.

12 Why Save? Saving is necessary to accumulate the capital needed to produce wealth. This is just as true for individuals as for nations. The most effective way to begin saving is by identifying and eliminating some discretionary spending. It is virtually (if not completely) inconceivable to believe that it is not possible to spend less than you could spend. A good practice for students (or anyone for that matter) is to keep a detailed spending log for at least a week, preferably longer. When you are able to see in black and white the frivolous expenditures we all make, it is very easy to identify areas in which your personal spending can be scaled back. Even if you start small, like cutting out trips to the grocery store or the vending machine, you can decrease your extraneous spending and start/add to a personal savings plan.

13 Don’t Wait!!! If you don’t 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 is extremely costly in terms of the amount of money you will end up with at retirement. Habits of all kinds are difficult to form-a savings habit is no exception. Waiting to form a savings habit not only makes said task more difficult, it is also extremely costly! As will be demonstrated again with “Practical Element #7”, to create wealth, you need to enable compound interest to work for you, earning money on top of money already earned.

14 There’s No Need to Suffer!
Congress has made it possible to save with before-tax dollars. Savings is deducted from your taxable income, thereby reducing your taxable income. Many types of tax-deferred savings plans: IRAs, 401(k) plans, 403(b) plans, etc. There are MANY creative ways to spend less. Pay yourself first! Make saving a regular expense. “Just do it!” A good assignment for students is to research some of the types of savings vehicles listed above. Of course, while certain instruments are not available to everyone (depending on your place of employment etc.), anyone interested in finding a tax friendly savings instrument ought to have no trouble.

15 Don’t finance anything for longer than its useful life.
Practical Element #4 Don’t finance anything for longer than its useful life.

16 Financing Consumption
Why continue to pay for something- a car, a vacation, a television- that you are no longer able to use and enjoy? Purchase on credit only when buying a long-lasting asset with short-lasting financing. Financing depreciating assets has become increasingly popular. This is not to say that it is never appropriate to buy on credit (see next slide), but rather that you should pay immediately for goods and/or services you plan to consume immediately.

17 When should you buy on credit?
What goods and services can you pay for while you use them? homes automobiles (depending on lifespan) education Some assets even generate income or further service even after you finish paying for them…these can enhance your net worth!!! Financing an education is of course one of the best uses of credit going, as your future income potential increases exponentially the more education you acquire. Of course there are exceptions, as certain fields/subjects of study are more in demand than others.

18 Avoid credit card debt and consider purchasing used items.
Practical Element #5 Two ways to get more out of your money: Avoid credit card debt and consider purchasing used items.

19 Don’t Undermine Your Future!!!
The opportunity cost of saving for tomorrow is spending (and enjoying!) today. You CAN have more in the future while still enjoying today… Again the message directed toward students here is not one pf privation. Instead, try to get students to focus on how they can continue to enjoy current consumption while simultaneously saving for the future (or at least not undermining it…) “…ordinary people can have lots of nice things and still accumulate a lot of money.”

20 Credit Card Convenience
Paying with a credit card is NOT spending your own money, but borrowing someone else’s. Interest charged on credit cards outstrips returns that could be earned on investments!!! Think of your credit card as an extension of your checking account…Use your credit card only to access those funds. The first point above may be the most important to emphasize to students. Especially in the era of the debit card, it is extra important to emphasize that using a credit card as payment is NOT using your own money and paying immediately, but rather taking out a loan from someone else (Visa?) that must be repaid at a later date. Again, credit cards are not inherently evil. In fact, it is wise to have one. They provide a secure method of payment in many instances and enable the holder to avail themselves of many conveniences, such as renting a car or reserving a hotel room.

21 The World’s Most Expensive Vacation
Sean charges $1,500 for a trip to the Bahamas. He pays the minimum payment ($26.63 at 8% interest) each month. 10 YEARS LATER this trip has cost Sean $3,195.40, and all he has left are faded photos. Note that this is the same example used in the text. It is also useful to point out to students, as in the text, that Sean has ultimately paid more in interest to his credit card company than he paid for the actual vacation.

22 It Pays to Buy Used! Can a used item satisfy you as well as a new item? Balance the time it takes to search for these items with the value of your time. There are savings to be had without having to sacrifice consumer satisfaction! Emphasize to students that purchasing used goods may entail higher search costs than buying new (though not always). The authors are not suggesting that an inordinate amount of time be spent scouring thrift shops and swap meets…Each individual, who best know the value of their own time, must determine how much search to undertake in the quest for these savings.

23 Begin paying into a “real-world” savings account every month.
Practical Element #6 Begin paying into a “real-world” savings account every month.

24 Rainy Days & the Real World
Life is full of surprises, and they’re usually expensive! The surprise is only in the timing…So it IS possible to plan for these surprises! Purchase “peace of mind” by building a cushion…Make this a regular and mandatory expense! People who do not plan for the unplanned do not live in the real world. SOMETHING unexpected will always arise, and seemingly always at the “wrong time”. Cars break down, illnesses happen, family emergencies and celebrations occur, etc. Such occurrences are easily handled when one has a “rainy day”, or “real world” savings stash handy.

25 Put the power of compound interest to work for you.
Practical Element #7 Put the power of compound interest to work for you.

26 It’s a Miracle!!! Getting a head start brings a HUGE payoff.
Compounding occurs when the interest you’ve already earned earns even more interest on itself.


28 Diversify- don’t put all of your eggs in one basket.
Practical Element #8 Diversify- don’t put all of your eggs in one basket.

29 Risk vs. Return There is no such thing as a guaranteed return!
There are many types of risk that come with investing: Market risk Inflation risk Financial risk Fraud risk There is no such thing as a guaranteed return! Diversification is the practice of holding a large number of unrelated assets.

30 The Law of Large Numbers
Mutual funds are one way of diversifying investments in the stock market. While diversification cannot reduce the volatility of the stock market, it WILL reduce the volatility of your investment in it. When some firms do poorly, others do well. Business cycles have differential effects on companies.

31 Double Jeopardy Does your employer offer a company stock-based retirement program? IF you have confidence in the company, take advantage of the opportunity. As soon as the plan permits, sell these shares to purchase other investments. Failure to do so puts you in double jeopardy …You are now beholden to your employer both for your job and your retirement investment. You are NOT diversified!!!

32 Practical Element #9 Indexed equity funds can help you beat the experts without taking excessive risk.

33 The Random Walk Theory No one can predict the future of the stock market. The random walk theory suggests that current stock prices are the best reflection of the market’s value. The future price of a stock is driven by unforeseeable events. Since we can only see the present, it is impossible to “beat the market”.

34 Invest in stocks for long-run objectives;
Practical Element #10 Invest in stocks for long-run objectives; as the need for money approaches, increase the proportion of bonds.

35 What About Diversification?
Merely an extension of the diversification concept… Because the stock market is volatile, you want to reduce your risk when you know you need a cash stash. Avoid selling off stocks when the market is at a low point.

36 So Why Not Just Hold Bonds?
Bonds offer a lower return than stocks, but with less risk. Inflation risk and interest rate risk are larger problems with bonds. Buy bonds that mature at the time you anticipate needing the cash. Transfer capital gradually from stocks to bonds.

37 Practical Element #11 Beware of investment schemes promising high returns with little or no risk.

38 There’s no such thing as a free lunch!!!
If it’s such a good deal, why do they need to sell it to you??? The principal-agent problem makes you vulnerable. A potential conflict exists between the investor and the agent being paid to do something for the investor…Because the agent has more information about the product than you, you are at a disadvantage.

39 Tips for Avoiding Investment Fraud
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 . 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!!!

40 Teach your children how to earn money and spend it wisely.
Practical Element #12 Teach your children how to earn money and spend it wisely.

41 Teach Your Children Well
Teach children money is earned …It doesn’t 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 them…Financial success is no different!

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