Making Financial Decisions Chapter 1

Your Life Situation and Financial Planning Personal Financial Planning Process of managing your money to achieve personal economic satisfaction Allows you to control your financial situation Can assure the quality of your life and increase your satisfaction by reducing uncertainty about future needs and resources

Your Life Situation and Financial Planning Formalized report that summarizes your current financial situation, analyzes your financial needs, and recommends future financial activity Can be created on your own or by a financial planner

Your Life Situation and Financial Planning Advantages of financial planning: Increased effectiveness in obtaining, using, and protecting your financial resources Increased control of your financial affairs by avoiding excessive debt, bankruptcy, and dependence on others Improved personal relationships resulting from well-planned and effectively communicated financial decisions A sense of freedom from financial worries obtained by looking to the future, anticipating expenses, and achieving personal economic goals

Your Life Situation and Financial Planning Factors that influence daily financial decisions Age Income Household size Personal beliefs Financial situation Family situation Events Values

Your Life Situation and Financial Planning Values What is important to your family, others in your culture? Peers People you know Pressure for positive or negative behaviors Habits You are accustomed to doing it this way Feelings (love, anger, frustration, ambivalence, rejection) If you do make a certain decision If you don’t make a certain decision E. Family Your family’s preference Decisions other family members have made F. Risks and consequences What (or how much) you stand to win What (or how much) you stand to lose G. Age Minor Adult

Financial Planning in Our Economy Economics Study of how wealth is created and distributed Includes various institutions: Individual consumers and investors Using cash or credit to purchase goods and services Saving money in a bank account Investing money in stocks, mutual funds, bonds, etc. Businesses Sell products or services Use money to pay for operating expenses and profits for investors Borrow money to make improvements, hire new employees Government Collects taxes to provide public services Borrow money to finance various projects

Common Decision Making Strategies spontaneity Choosing the first option that comes to mind; giving little or no consideration to the consequences of the choice. compliance Going along with family, school, work, or peer expectations. procrastination Postponing thought and action until options are limited. agonizing Accumulating so much information that analyzing the options becomes overwhelming. intention Choosing an option that will be both intellectually and emotionally satisfying. desire Choosing the option that might achieve the best result, regardless of the risk involved. avoidance Choosing the option that is most likely to avoid the worst possible result. security Choosing the option that will bring some success, offend the fewest people, and pose the least risk. synthesis Choosing the option that has a good chance to succeed and which you like the best.

Economic Factors Affecting Financial Activities consumer prices changes in the buying power of the dollar, inflation consumer spending demand for goods and services gross domestic product (GDP) total value of goods and services produced within the country housing starts the number of new homes being built interest rates the cost of borrowing money money supply funds available for spending in the economy stock market index (such as the Dow Jones averages, Standard & Poor’s 500) indicate general trends in the value of U.S. stocks unemployment the number of people without employment who are willing to work

Financial Planning Activities Obtaining Obtaining financial resources through employment, investments, or ownership of business Foundation of financial planning Planning Spending through budgeting is the key to achieving goals and future financial security Saving Regular savings plan for emergencies, unexpected bills, replacement of a major item, and purchase of special goods and services (college education, boat, vacation home)

Financial Planning Activities Borrowing Maintaining control over credit-buying habits Spending Spending less than you earn is the only way to achieve long-term financial security Managing Risk Adequate insurance coverage

Financial Planning Activities Investing Current income—select investments that pay regular dividends or interest Long-term growth—choose stocks, mutual funds, real estate, and other investments with potential for increased value in the future Retirement and Estate Planning Planning for financial security upon completion of full-time work Thinking about housing situation, recreational activities, and possible part-time or volunteer work

Developing and Achieving Financial Goals Types of Financial Goals Short-term--Goals to be achieved in the next year or two Intermediate--Time frame of two to five years Long-term--Financial plans more than five years off Should be in line with short-term and intermediate goals

Types of Purchases Consumable-product Occur on a periodic basis and involve items that are used up relatively quickly (food, clothing, entertainment) Durable-product Usually involve infrequently purchased, expensive items (appliances, cars, sporting equipment) Intangible-purchase Relate to personal relationships, health, education, and leisure

Goal Setting Guidelines Effective financial goals should be: Realistic Stated in specific, measurable terms Based on a time frame Action oriented SMART Goals Specific Measurable Attainable Time bound

Opportunity Costs and the Time Value of Money What you give up to get something else Commonly referred to as a trade-off Cannot always be measured in dollars Personal Opportunity Cost Involves time or health Financial Opportunity Cost Time value of money—increase in amount of money as a result of interest earned Every time you save, spend, invest, or borrow money, you should consider the time value of that money as opportunity cost

Risks Associated with Decision Making personal risks factors that may create a less than desirable situation. Personal risk may be in the form of inconvenience, embarrassment, safety, or health concerns. inflation risk rising prices cause lower buying power. Buying an item later may mean a higher price. interest-rate risk changing interest rates affect your costs (when borrowing) and your benefits (when saving or investing). income risk changing jobs or reduced spending by consumers can result in a lower income or loss of one’s employment. Career changes or job loss can result in a lower income and reduced buying power. liquidity risk certain types of savings (certificates of deposit) and investments (real estate) may be difficult to convert to cash quickly.

Financial Opportunity Costs Interest Calculations Amount of savings Annual interest rate Length of time of deposit Future Value of a Single Amount Amount to which current savings will increase based on a certain interest rate and a certain time period Also referred to as compounding interest Future Value of a Series of Deposits Annuity—series of equal deposits or payments

Financial Opportunity Costs Present Value of a Single Amount Current value for a future amount based on a certain interest rate and a certain time period Also called discounting Allow you to determine how much to deposit now to obtain a desired total in the future Present Value of a Series of Deposits Determine how much to deposit so you can take out a certain amount for a desired number of years

A Plan for Personal Financial Planning Determine current financial situation Develop financial goals Identify alternative courses of action Continue on same course Expand current situation Change current situation Take new course of action

A Plan for Personal Financial Planning Evaluate your alternatives Consequences of choices Evaluating risk Financial planning information resources Create and implement your financial action plan Review and revise your plan