Section 4 12 Key Elements of Practical Personal Finance Tatiana Pino April 11 2011 Financial Insecurity in America Financial insecurity in the US does not exist because incomes are too low but exists because consumption per person is growing More consuming less saving more debt Credit card debt is rampant Is America in Trouble Real income per person is rising but o Savings rate is falling o Debt is increasing Planning for Financial Success The Importance of Financial Security Financial security leads to o Less conflict in marriage o Better health o Retirement o A greater ability to achieve personal goals The bad news Failure to save regularly conserve wisely invest strategically and use credit cards prudently is the major cause of financial insecurity in America The good news Each one of these things is fixable The 12 Key Elements of Personal Finance financial security into the future The following is a list of fundamental steps that are necessary for achieving wealth and 1 Discover Your Comparative Advantage Discover what you can produce at a lower opportunity cost than other people Start now Don t just think about money your opportunity cost includes your personal satisfaction as well Remember in market economy people get rich by helping others and discovering better ways 2 Be Entrepreneurial of doing things Entrepreneurial talent involves the ability to discover o A New products that are highly valued relative to their costs Endless possibilities o B Cost reducing production methods o C Profitable opportunities that others overlook It is hard to know what will work Requires the tolerance for risk o Entrepreneurial activity and self employment are riskier than being employed by someone else Entrepreneurs tend to o This greater risk can translate into higher income and wealth o A Have high savings rates they are often reinvesting in their businesses o B Work long hours and work more strategically o A free market economy tends to promote entrepreneurship 3 Spend Less Than What You Earn Savings and investment are the most likely ways you can become rich Start saving now 2 April 13 2011 o A If you don t exert the willpower to save now it is unlikely that you will start later o B The longer you wait to start saving the more potential wealth you give up You only have to save a little Start out saving small amounts and then build up to larger amounts o A journey of a thousand miles begins with a single step Lao Tzu Save automatically You can have the money automatically deducted from your paycheck or bank account for savings Save strategically Tax Deferred Savings government cannot touch it o 401 k retirement account not taxed right now matching program employers will match it up to a certain level like giving you free money to attract employees Want to put the most you can into 401k so that you can get the most matched Don t count on Social Security to exist when it s time for us to retire o Traditional IRA s reduces tax bill now taxed later o Roth IRA s taxed now not taxed later 4 Don t Finance Anything Longer Than Its Usual Life You don t want to be paying for things long after your done consuming them Three things worth financing taking out loans or putting on credit o House Only buy a house with at least 20 down payment Better credit history better interest rate on loans Pay credit and bills on time Buying a house is not risk free 3 Only buy a house if you plan on living there for a long period can ride out bad downturns o Education o Automobiles in some cases Things you don t want to finance o Food o Clothing o Entertainment o Vacations o Enjoy it quickly and then end up paying off for a long time 5 Get More Out of Your Money A Avoid credit card debt o 1 Interest rates on credit cards are very high usually higher than savings and investment return rates average credit card interest rate is 15 39 o 2 Always pay your credit card in full and on time o Important to establish good credit history o Wise to use credit card like a debit card just to be safe B Consider purchasing used items o 1 New cars lose substantial value as soon as they are driven off of the lot good if you re going to own it for a long time o 2 Used cars have higher maintenance costs but depreciation costs are much lower good if going to own for a shorter period of time April 18 2011 6 Begin Paying Into A Real World Savings Account Every Month Things are going to go wrong it s just a matter of when 4 o Estimated that every 10 years a major and costly event will occur in your life Make contributions to an emergency savings account a regular part of your budget 7 Harness the Power of Compound Interest Mr Einstein what is the most powerful force in the universe Compound Interest saving early to become wealthy The Rule of 70 Divide by 70 by the expected rate of return and you will see how long it takes for your investment to double can also work with 72 o All about saving early o 70 rate of return interest rate receiving from investment 8 Diversify Do not put all of your eggs in one basket Investment involves risk especially in the short run Mitigate this risk by building a diversified portfolio Historically long term returns of stocks have been really good Just make sure you o Hold a large number of unrelated stocks o Hold stocks for a lengthy period of time about 10 15 years The Law of Large Numbers the tendency over an increasing number of observations for the sample average to approach the population average the expected value o i e if you flip a coin enough times you will see that the probability of flipping heads over tails and visa versus will be 50 50 the expected value o If you hold a diversified set of stocks some will do poorly while others will do well so that the rate of return will converge toward the historic average of the stock market 7 Avoid Double Jeopardy o If your company offers you a stock based retirement program then you may want to sell your company s shares as soon as you are permitted Companies do this to give you an incentive to work better o If you don t and the company goes under then you have lost your job and your investment Types of investments from less risky to more risky from lower return to higher return checking account savings account CD CD ladder pay attention to expiration dates mutual funds individual stocks 9 Indexed Equity Funds Can Help You Beat the Experts Without Taking Excessive Risk Random Walk Theory Current stock prices reflect all known information about the company