Overview of the Financial Plan
The objectives of this chapter are to:
- Introduce the reader to the subject of personal finance.
- Identify the key components of a financial plan.
- Outline the steps to begin creating a personal financial plan (PFP).
Why Study Personal Finance?
Personal finance is the process of planning your savings, spending, and investing in order to maximize your optimal financial situation. A personal financial plan specifies your specific financial goals and describes the savings, spending, and investing tools you are going to use to meet your financial goals. Creating and managing your financial plan is a life-long process that involves time and commitments. As anything worth having, a good financial plan requires attention. But the benefits of creating a financial plan include:
- Giving you the knowledge you need to make your own financial decisions. Each of us has to determine the opportunity cost of our spending decisions. The opportunity cost represents what you give up as a result of your decisions. By spending money for one item you forgo the opportunity to spend that same money on another option, saving it or investing it.
- Allows you to become financially successful. Although many people believe financial success has to do with how much money a person makes, really it means obtaining the maximum benefits from limited financial resources. Some people who have a lot of money are good at this, some are bad. This means a person can become a financial success (or failure) regardless of their income level. Financial objectives are rarely achieved without restraining current consumption (spending on goods and services). To accomplish this restraint you can 1) put money into savings (income not consumed) to be used on your future goals; 2) invest (using capital to create more money). By saving and investing you are more likely to have funds for future goals.
Saving for short- middle- and long-term goals represents a desire for you to achieve a certain standard of living. This standard is what an individual is striving to attain, to maintain once attained, and preserve if threatened. At any given time an individual is at their level of living. In essence, our level of living is where we are right now, our standard of living is where we’d like to be.
- Helps you understand your goals and whether you are moving toward or away from those goals. In order to understand how your finances fit into the rest of your life you need to look at both financial and non-financial goals
- Financial goals form the basis for financial planning. These goals need to be identified at the beginning of the process of putting your personal financial plan together. There are four steps to creating goals: 1) Evaluate your current financial situation. Create an income statement and a balance sheet to help you. 2) Define your financial goals. These goals need to be concrete goals. Financial goals need to be time and dollar specific. A goal that states “I want to have a nice car.” Does not give enough specifics to save toward. A goal that says “I want a $30,000 car by December 31, 2010.” Gives time and money specificity. Now you can start creating a plan to determine how you’re going to achieve that goal. 3) Develop your plan of action. When making mid- or long-term goals you may need short-term goals to support them. 4) Implement your plan (as some of us country music lovers would say “Just LeDoux it!!”). 5) Evaluate your performance toward your goals. At least annually analyze your performance and determine if you need to revise or adjust your goals.
- Non-financial goals are those goals that have to do with your physical, emotional, spiritual, etc. aspirations. Many of these goals may require money to achieve while others do not. However, achieving financial goals may give you more opportunities to enjoy these goals.
Figure 1.1 The Planning Process
Money Matters
Would winning the lottery make you happy? Not likely. According to David G. Myers, a happiness researcher, money does not buy happiness. Rich people are no more happy than people with average incomes. In addition, older people are neither less nor more happy than young people. And men have no advantage over women. So who is happy?
Only about 10-15 percent Americans identify themselves as truly happy. Certain personality traits, such as extroversion, agreeableness, and conscientiousness, are related to happiness. However, in the right situation, anyone can be happy.
Psychologist Mihaly Csikszentmihalyi has observed that people are most satisfied with life when their work and leisure life provide them opportunity to use their skills. Somewhere between the anxiety of being overwhelmed and the apathy of being bored is the ideal mix called "flow." Happy people have more flow. They are appropriately challenged in ways that allow them to personally contribute.
Happiness has also been linked to meaningful relationships. Individuals who are happy are supported by close relationships with family members, friends, and fellow employees. Such relationships help fulfill our need to belong to something bigger than ourselves. The network of friends and family also provides us with opportunities to help or be helped. If we are to maintain a healthy balance in life, we will eventually need help from others. Perhaps this partly explains the finding that married individuals, both male and female, are on average happier than single individuals.
Finally, happy people are more likely to be involved in a faith community. A Gallup survey found people who responded with the highest scores on spiritual commitment were twice as likely to declare they were very happy. Other research has suggested those with deep religious faith are less vulnerable to depression and more resilient during times of crisis. Meyers notes that religion is usually practiced communally, involving "the fellowship of kindred spirits," and "the bearing of one another’s burdens."
So, if happiness is your goal, forget the lottery tickets. Instead, take a friend to lunch. Help a fellow worker. Set your sights on a challenge and enjoy the experience. Look to your network of friends and family. Use your skills to make a difference at home and at work.
Applications:
To strengthen your personal happiness and add to the joyfulness of you family experience try some of the following:
1. Work on something challenging.
2. Do something for others
3. Smile often
4. Join a group. Participating in a club, a church group, or community group can create many opportunities.
5. Give someone a break.
Source: University of Arkansas Cooperative Extension Service
Setting Personal Financial Goals
Setting goals should be nothing new to you. You have probably done it hundreds of times in your life. You may have a target GPA, a date that you are shooting at to graduate, or places you would like to visit in your life time. Most of us know what we need to do to attain these goals. But when it comes to financial goals, though we may have them – “I want to retire with 2 million dollars” or “I want to save enough money so I don’t have to worry about finances when I retire.” The problem is figuring out how to go about achieving these goals.
As with any worthwhile goal, financial goals will require you to reach higher and farther than you ever have before. You will have to spend some time planning your financial journey just as you would have to plan any trip, this process will take some time. Once you reach a location on this journey you will be given the opportunity to look back on what you have accomplished, would you have changed anything? If you would have, make the change, put your financial gear back on, and move forward to your next location along your journey. The difference between this trip and other trip you will take is that this expedition will last a life time. In order to reach your destination you will need to work at it. You will have to get yourself in good financial health to cross some of the financial deserts, mountains, and waters that may get in your way between here and there. But, if you take the time to prepare and use the tools and equipment available to you, you will succeed.
Financial goals cover three time horizons: (1) short-term, (2) intermediate-term, and (3) long-term. Short-term goals can be accomplished within the next twelve months. Intermediate-term goals are goals that will take more than one year but less than ten years to accomplish. Long-term goals will take more than ten years for you to complete.
FiFigure 1.2Personal Financial Goals
Short-Term Goals / Dollar Amount / Date to
Financial Goal / to Accomplish / Accomplish By
1. / Go
2.
3.
4.
5.
Intermediate-Term Goals
1.
2.
3.
4.
5.
Long-Term Goals
1.
2.
3.
4.
5.
This spreadsheet is also located in your PFP under the “Goals” tab. Use the five steps included on that spreadsheet to complete your personal financial goals worksheet. This is a very important part of your financial journey. In fact, your goals should be your Global Positional System (GPS) on this journey. Any time you wonder whether or not you are making the correct financial decision ask yourself “does this help me achieve one of my personal financial goals?” If the answer is no, you should rethink the way you were thinking about using your money. This process of setting and revising goals should be a long-term commitment to your personal finance health.
When making long-term goals it is important to understand something about the economy. What is the “traditional” inflation rate, what kind of interest can one expect to make on an investment, etc. This is important because you are trying to determine how much money you need in fifteen, twenty, maybe thirty years from now. We will talk about time value of money and its importance in Chapter 2, but right now let’s just talk about economic trends that may affect your decisions.
Understanding Important Economic Trends
Understanding personal finances would be so much easier if we lived in an economic environment where nothing changes – but that environment does not exist. So we need to be able to predict what might happen in the future based on past experiences. Certain trends in the economy are pretty good predictors of the future. In the United States the federal government attempts to regulate the economy to maintain stable prices, stable employment, and controlled inflation. By doing this the government hopes to attain economic growth, which is a condition of increased production and consumption in the economy. If this growth occurs there is increased national income. Because it is impossible for this growth to constantly move upward, there are phases that occur throughout time. These phases create a wave-like pattern called the business cycle (or economic cycle). These temporary phases include expression, recession (sometimes moving into depression), and recovery.
The preferred stage in the economic cycle is the expansion phase. This is a time when production is high, unemployment is low, retail sales are on the rise, prices are low, and interest rates are falling. When the economy is growing very strongly, the Federal Reserve typically tries to engineer a soft landing by raising interest rates to head off inflation. When this occurs, the economy will move toward a recession, which is generally described as a decline in production. During this phase of the cycle the Federal Reserve will generally lower interest rates to stimulate growth. As rates are lowered and the economy recovers, it heads into the recovery phase of the business cycle, where production, unemployment rates, and retail sales begin to improve. Historically the business cycle takes four to five years to complete.
Figure 1.3 Phases of the Business Cycle
Let’s look at some of these:
The Consumer Price Index (CPI)is a monthly indicator of the changes in the prices paid by urban consumers for a representative basket of goods and services. As figure 1.3 points out, the CPI has drastically changed since the late ‘70’s and early ‘80’s. The CPI is one of the indicators looked at to determine inflation because if the average household is paying 3% more this year for this basket of goods than last year, the inflation rate is about 3%.
Figure 1.4 Consumer Price Index
Source: Federal Reserve Bank of St. Louis, National Economic Trends May 2005, p.8
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Using the raw data provided in Appendix 1 of this chapter you can determine the average increase in prices from one period to another.
Example:
The CPI is used to calculate how prices have changes over the years. Let’s say you wanted to buy a $7 item in 2005 . How much would you have needed in 1950 to purchase that same item?
The CPI for 1950 = 24.1
The CPI for 2005 = 194.6
Use the following formula to compute the calculation:
1950 Price = 2005 Price x (1950 CPI / 2005 CPI)
1950 Price = $7.00 x (24.1 / 194.6)
1950 Price = .87
Therefore, based on the CPI, an item that cost 87 cents in 1950 would cost $7.00 in 2005. Remember, this does not mean everything increased at this rate. The CPI represents the consumer’s basket of goods. Some prices grow faster and some grow slower.
So, if you were planning a long-term goal and trying to anticipate the increased cost of the product in five, ten, even thirty years the CPI would be a place to start estimating the increased cost for that item. At the same time, your investments should grow faster than the inflation rate to grow your wealth in real terms.
Real Gross Domestic Product (GDP) measures the value of a nation's output of goods and services for some period of time, usually a year. It is not the only measure of output but the GDP has become a favorite among economists because it is the most comprehensive of output measures. The impacts the GDP can have on the economy are:
Interest Rates:Unexpectedly high quarterly GDP growth is perceived to be potentially inflationary if the economy is close to full capacity; this, in turn, causes bond prices to drop and yields and interest rates to rise. Also, higher than expected GDP growth, i..e. good news about the economy, is bad news for the bond market because a strong report causes concern that the Fed might raise the Fed Funds rate to avoid higher inflation. This is bearish for the fixed income market.
Stock Prices: Ambiguous. On one side higher than expected growth leads to higher profits and that's good for the stock market. On the other, it may increase expected inflation and lead to higher interest rates that are bad for the stock market.
Exchange Rates: Larger than expected GDP growth will tend to appreciate the exchange rate as it is expected to lead to higher interest rates.
Figure 1.4 provides a measurement of our economy’s performance since 1979. As you can see there have been four recessions, each has had an impact on American families in terms of savings, investing, and spending. There is no reason to believe this trend will not continue, therefore financial plans need to anticipate possible economic instability.
Figure 1.5 Gross Domestic Product
Source: Federal Reserve Bank of St. Louis, National Economic Trends May 2005, p.4
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These are only a couple of the many economic indicators that exist. In addition to paying attention to these trends, you should stay abreast of what is going on in the financial news and what changes are occurring that could impact your financial plans.
How Inflation Affects Income and Consumption
When prices are increasing and individual’s income must rise at the same rate in order to maintain purchasing power. If inflation rates are greater than an individual’s salary increase the individual is said to have lost purchasing power. When the increase in salary is larger than inflation the individual has increased his/her purchasing power. When looking at one’s income, we need to clarify whether we are looking at nominal income, the salary you and your employer agree upon. For example, when you take a job for $35,000, that is your nominal income. It is unadjusted for change in the purchasing power of the dollar. The other, and more important income, is real income. This is the income an individual receives after adjusting for changes in purchasing power caused by inflation. A price index is used to determine the difference between the purchasing power of a dollar in a base year and the purchasing power now. For instance, if cost of a market basket increases from $100 to $120 in ten years, reflecting a 20% decline in purchasing power, salaries must rise 20% if real income is to be maintained.
To equate this to one’s annual wage, let’s assume that Jenny, our retail manager that was making $30,000 was to get increases of $500, $600, and $700 over the following three years after her initial hire. Let’s also assume that inflation has been 3% for these same years. Although Jenny’s nominal income has increased from $30,000 to $31,800 ($30,000 + $500 +$600 + $700), her purchasing power has decreased. In order for her purchasing power to have stayed the same, she would need to be making $32,782 ($30,000 x 1.03 = $30,900 x 1.03 = $31,827 x 1.03 = $32,782). In other words, Jenny has lost $982 of purchasing power.
Another way to compare annual wage increases with the rate of inflation is to convert the raise into a percentage and compare that percentage to the inflation rate: