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CommonSenseEconomics.com1 Twelve Key Elements of Practical Personal Finance Common Sense Economics James Gwartney, Richard L. Stroup, and Dwight R. Lee.

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Presentation on theme: "CommonSenseEconomics.com1 Twelve Key Elements of Practical Personal Finance Common Sense Economics James Gwartney, Richard L. Stroup, and Dwight R. Lee."— Presentation transcript:

1 CommonSenseEconomics.com1 Twelve Key Elements of Practical Personal Finance Common Sense Economics James Gwartney, Richard L. Stroup, and Dwight R. Lee CommonSenseEconomics.com

2 2 Why Is There Financial Insecurity in America? Do You Think It Is Because Incomes Are Low? See next slide.

3 CommonSenseEconomics.com3 U.S. Income Is Rising and Has Never Been Higher

4 CommonSenseEconomics.com4 Consumption Per Person Is Also Growing

5 CommonSenseEconomics.com5 Financial Insecurity: Let’s take a look at how households divide their income between consumption and savings. Remember, saving helps households prepare for surprise expenditures.

6 CommonSenseEconomics.com6 U.S. Saving Rates Are Falling While Consumption Rates Are Rising …

7 CommonSenseEconomics.com7 And Interest on Household Debt as a Percentage of Income

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11 CommonSenseEconomics.com11 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.

12 CommonSenseEconomics.com12 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.

13 CommonSenseEconomics.com13 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

14 CommonSenseEconomics.com14 “If you don't know where you are going, you might wind up someplace else.” ~ Yogi BerraYogi Berra

15 CommonSenseEconomics.com15 Practical Element of Personal Finance #1 Discover your comparative advantage.

16 CommonSenseEconomics.com16 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.

17 CommonSenseEconomics.com17 Farmer John vs. Nurse Kelly: Can They Gain From Specialization and Trade?

18 CommonSenseEconomics.com18 What’s 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?

19 CommonSenseEconomics.com19 Practical Element of Personal Finance #2 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.

20 CommonSenseEconomics.com20 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! Entrepreneurs fuel economic growth and development!

21 CommonSenseEconomics.com21 Entrepreneurs’ Success: 1. Entrepreneurial talent: the ability to discover a. new products that are highly valued relative to costs, b. cost-reducing production methods, and c. profitable opportunities that others overlook. 2. 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.

22 CommonSenseEconomics.com22 Entrepreneurs’ Success (cont.) 3. High Savings Rates: Entrepreneurs have high savings rates. Often they invest in their businesses, adding to their wealth. 4. Work Hard and Smart: Entrepreneurs, business owners and independent contractors tend to work longer hours and more strategically.

23 CommonSenseEconomics.com23 Practical Element of Personal Finance #3 Spend Less Than You Earn

24 CommonSenseEconomics.com24 Why Should You Save? Increase your wealth. Live a less stressful, more financially free life. Achieve high consumption levels in the future.

25 CommonSenseEconomics.com25 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.

26 CommonSenseEconomics.com26 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.

27 CommonSenseEconomics.com27 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. Nothing. The coffee is consumed! b. $1,460 c. $73,000 d. $ 443,918

28 CommonSenseEconomics.com28 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.

29 CommonSenseEconomics.com29 Practical Element of Personal Finance #4 Don’t finance anything for longer than its useful life.

30 CommonSenseEconomics.com30 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. Don’t build up debt unless it is strategic!

31 CommonSenseEconomics.com31 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).

32 CommonSenseEconomics.com32 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.

33 CommonSenseEconomics.com33 Practical Element of Personal Finance #5 Get More Out of Your Money 1. Avoid credit card debt. 2. Consider purchasing used items.

34 CommonSenseEconomics.com34 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.”

35 CommonSenseEconomics.com35 Credit Card Convenience Paying with a credit card is NOT spending your own money, but borrowing someone else’s 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 account…Always pay your credit card bill in full.

36 CommonSenseEconomics.com36 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.minimum of $50 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? $1300 in interest! And the items costing $2000 are gone!

37 CommonSenseEconomics.com37 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.Edmunds.com

38 CommonSenseEconomics.com38 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?

39 CommonSenseEconomics.com39 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?

40 CommonSenseEconomics.com40 Practical Element of Personal Finance #6 Pay into a “real-world” savings account every month.

41 CommonSenseEconomics.com41 Rainy Days & the Real World Life is full of “surprises”, and they’re usually expensive! Cars break down. Heaters and air conditioners go. People get sick or injured.

42 CommonSenseEconomics.com42 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!

43 CommonSenseEconomics.com43 Practical Element of Personal Finance #7 Put the power of compound interest to work for you.

44 CommonSenseEconomics.com44 It’s 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!

45 CommonSenseEconomics.com45 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)

46 CommonSenseEconomics.com46 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) Age 37? $16,000 Age 51? $64,000 ($16,000 + $16,000 + $32,000)

47 CommonSenseEconomics.com47 Practical Element of Personal Finance #8 Diversify - don’t put all of your eggs in one basket.

48 CommonSenseEconomics.com48 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!

49 CommonSenseEconomics.com49 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.

50 CommonSenseEconomics.com50 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!

51 CommonSenseEconomics.com51 Practical Element of Personal Finance #9 Indexed equity funds can help you beat the experts without taking excessive risk.

52 CommonSenseEconomics.com52 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”.

53 CommonSenseEconomics.com53 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.

54 CommonSenseEconomics.com54 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.

55 CommonSenseEconomics.com55 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.

56 CommonSenseEconomics.com56 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.

57 CommonSenseEconomics.com57 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”.

58 CommonSenseEconomics.com58 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.

59 CommonSenseEconomics.com59 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.

60 CommonSenseEconomics.com60 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.

61 CommonSenseEconomics.com61 Practical Element of Personal Finance #11 Beware of investment schemes promising high returns with little or no risk.

62 CommonSenseEconomics.com62 There’s 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.

63 CommonSenseEconomics.com63 Tips for Avoiding Investment Fraud 1. If it looks too good to be true, it probably is. 2. Deal only with parties that have a reputation to protect. 3. Never purchase an investment solicited by telephone or Do not allow yourself to be forced into a quick decision. 5. Do not allow friendship to influence an investment decision. 6. If high-pressure marketing is involved, grab your checkbook and run!!!

64 CommonSenseEconomics.com64 Practical Element of Personal Finance #12 Teach your children and others how to earn money and spend it wisely.

65 CommonSenseEconomics.com65 Teach Your Children Truths About Money Teach children money is earned by providing services others’ value…Money 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 them…Achieve financial success and security. Start now!


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