Prof Dr Ritesh Srivastava
Introduction Personal finance is the financial management which an individual or a
family unit performs to budget, save, and spend monetary resources over
time, taking into account various financial risks and future life events.
When planning personal finances, the individual would consider the
suitability to his or her needs of a range of banking products (checking,
savings accounts, credit cards and consumer loans) or investment in private
equity, (companies’ shares, bonds, mutual funds) and insurance (life
insurance, health insurance, disability insurance) products or participation
and monitoring of and- or employer-sponsored retirement plans, social
security benefits, and income tax management.
Before a specialty in personal finance was developed, various disciplines
which are closely related to it, such as family economics, and consumer
economics were taught in various colleges as part of home economics for
over 100 years.
The earliest known research in personal finance was done in 1920 by Hazel
Kyrk. Her dissertation at University of Chicago laid the foundation of
consumer economics and family economics.
[2] Margaret Reid, a professor of
Home Economics at the same university, is recognized as one of the
pioneers in the study of consumer behavior and Household behavior.
In 1947, Herbert A. Simon, a Nobel laureate, suggested that a decisionmaker did not always make the best financial decision because of limited
educational resources and personal inclinations.In 2009, Dan Ariely
suggested the 2008 financial crisis showed that human beings do not always
make rational financial decisions, and the market is not necessarily selfregulating and corrective of any imbalances in the economy.
Therefore, personal finance education is needed to help an individual or a
family make rational financial decisions throughout their life. Before 1990,
mainstream economists and business faculty paid little attention to personal
finance. However, several American universities such as Brigham Young
University, Iowa State University, and San Francisco State University have
started to offer financial educational programs in both undergraduate and
graduate programs in the last 30 years. These institutions have published
several works in journals such as The Journal of Financial Counseling and
Planning and the Journal of Personal Finance.
Research into personal finance is based on several theories such as social
exchange theory and andragogy (adult learning theory). Professional bodies
such as American Association of Family and Consumer Sciences and the
American Council on Consumer Interests started to play an important role in
the development of this field from the 1950s to 1970s.
The establishment of the Association for Financial Counseling and Planning
Education (AFCPE) in 1984 at Iowa State University and the Academy of
Financial Services (AFS) in 1985 marked an important milestone in personal
finance history. Attendances of the two societies mainly come from faculty
and graduates from business and home economics colleges. AFCPE has since
offered several certifications for professionals in this field such as Accredited
Financial Counselor (AFC) and certified Housing Counselors (CHC).
Meanwhile, AFS cooperates with Certified Financial Planner (CFP Board).
As the concerns about consumers’ financial capability have increased in
recent years, a variety of education programs have emerged, catering to a
broad audience or to a specific group of people such as youth and women.
The educational programs are frequently known as “financial literacy”.
However, there was no standardized curriculum for personal finance
education until after the 2008 financial crisis.
The United States President’s Advisory Council on Financial Capability was
set up in 2008 in order to encourage financial literacy among the American
people. It also stressed the importance of developing a standard in the field
of financial education.
Personal financial planning process
The key component of personal finance is financial planning, which is a
dynamic process that requires regular monitoring and re-evaluation. In
general, it involves five steps:
- Assessment: A person’s financial situation is assessed by compiling
simplified versions of financial statements including balance sheets and
income statements. A personal balance sheet lists the values of
personal assets (e.g., car, house, clothes, stocks, bank account), along
with personal liabilities (e.g., credit card debt, bank loan, mortgage). A
personal income statement lists personal income and expenses. - Goal setting: Having multiple goals is common, including a mix of
short- and long-term goals. For example, a long-term goal would be to
“retire at age 65 with a personal net worth of $1,000,000,” while a
short-term goal would be to “save up for a new computer in the next
month.” Setting financial goals helps to direct financial planning. Goal
setting is done with an objective to meet specific financial
requirements. - Plan creation: The financial plan details how to accomplish the goals.
It could include, for example, reducing unnecessary expenses,
increasing the employment income, or investing in the stock market. - Execution: Execution of a financial plan often requires discipline and
perseverance. Many people obtain assistance from professionals such
as accountants, financial planners, investment advisers, and lawyers. - Monitoring and reassessment: As time passes, the financial plan is
monitored for possible adjustments or reassessments.
Typical goals that most adults and young adults have are paying off credit
card/student loan/housing/car loan debt, investing for retirement, investing
for college costs for children, paying medical expenses.
Need for Personal Finance
There is a great need for people to understand and take control of their
personal finances. These are some of the overarching reasons for it; - No formal education for personal finance Most countries have a
formal education across most disciplines or areas of study.
Individuals pursue to learn in order to earn a livelihood.
Their pursuit translates to earning tangible outcomes in the form of
money.
Even when we realize the above to be a primary objective, there is no
formal education at an elementary level in schools or colleges to learn
money management or personal finance.
Hence, it is important to understand this gap or disconnect in the
education system where there is no formal way of equipping an
individual to manage his or her own money.
This illustrates the need to learn personal finance from an early stage,[10] in
order to differentiate between needs vs. wants[11] and plan accordingly. - Shortened employable age: Over the years, with the advent of
automation [12] and changing needs; it has been witnessed across the globe
that several jobs that require manual intervention, or that are mechanical in
nature are increasingly becoming redundant.
Several employment opportunities are shifting from countries
with higher labor costs to countries with lower labor .costs keeping
margins low for companies.
In economies with a considerably large younger population entering
the workforce who are more equipped with latest technologies, several
employees in the middle management[14] who have not up-skilled are
easily replaceable with new and fresh talent that are cheaper and more
valuable to the organizations.
Cyclical nature of several industries[15] like automobile, chemicals,
construction; consumption and demand is driven by the health of the
countries’ economy. It has been observed that when economies
stagnate, are in recession, in war – certain industries suffer more
compared to others. This results in companies rationalizing their
workforce. An individual can lose his/her job easily and remain
unemployed for a considerable time. All these reasons bring to the
realization that the legal employable age of 60 is slowly and gradually
becoming shorter.
These are some of the reasons why individuals should start planning for their
retirement and systematically build on their retirement corpus,] hence the
need for personal finance. - Increased life expectancy:
[17] With the developments in healthcare,
people today are living till a much older age than their forefathers. The
average life expectancy have changed over the years and people even in
developing economies are living much longer. The average life expectancy
has gradually shifted from 60 to 81[17] and upwards. Increased life
expectancy coupled with a shorter employable age reinforces the need of
PERSONAL FINANCE
having a large enough retirement corpus and the importance of personal
finance. - Rising medical expenses:
[18] Medical expenses including cost of drugs,
hospital admission care and charges, nursing care, specialized care, geriatric
care have all seen an exponential rise over the years. Many of these medical
expenses are not covered through the insurance policies that might either be
private/individual insurance coverage or through federal or national
insurance coverage.
In developed markets like the US,[19] insurance coverage is provided
by either the employers, private insurers or through federal
government (Medicare, primarily for senior citizens or Medicaid,
primarily for individuals of lower income levels). However, with the
rising US fiscal deficit and large proportion of geriatric population it
needs to be seen the extent of the Medicare program being sustainable
in the long run, therapy exclusions in the coverage, co-pay,
deductibles – there are several cost elements that are to be borne by
individuals on a continual basis.
In other developed markets like the EU, most of the medical care is
nationally reimbursed. This leads to the national healthcare budgets
being very tightly controlled. Many newer therapies that are
expensive, many a times are excluded from the national formularies.
This means that patients may not have access through the
government policy and would have to pay out of pocket to avail these
medicines
In developing countries like India, China, most of the expenses are out
of pocket[20] as there is no overarching government social security
system covering medical expenses.
These reasons illustrate the need of having medical, accidental, critical
illness, life coverage insurance for oneself and ones family as well as the
need for emergency corpus;[21] translating the immense need for personal
finance.
principles
Personal circumstances differ considerably, with respect to patterns of
income, wealth, and consumption needs. Tax and finance laws also differ
from country to country, and market conditions vary geographically and over
time. This means that advice appropriate for one person might not be
appropriate for another. A financial advisor can offer personalized advice in
complicated situations and for high-wealth individuals, but University of
Chicago professor Harold Pollack and personal finance writer Helaine Olenargue that in the United States good personal finance advice boils down to a
few simple points:
Pay off your credit card balance every month, in full
Save 20% of your income
Maximize contributions to tax-advantaged funds such as a 401(k)
retirement funds, individual retirement accounts, and 529 education
savings plans
When investing savings:
o Don’t attempt to trade individual securities
o Avoid high-fee and actively managed funds
o Look for low-cost, diversified mutual funds that balance risk vs.
reward appropriately to your target retirement year
If using a financial advisor, require them to commit to a fiduciary duty
to act in your best interest
The limits stated by laws may be different in each country; in any case
personal finance should not disregard correct behavioral principles: people
should not develop attachment to the idea of money, morally reprehensible,
and, when investing, should maintain the medium-long-term horizon
avoiding hazards in the expected return of investment.
Areas of focus
Key areas of personal financial planning, as suggested by the Financial
Planning Standards Board, are:] - Financial position: is concerned with understanding the personal
resources available by examining net worth and household cash flow.
Net worth is a person’s balance sheet, calculated by adding up all
assets under that person’s control, minus all liabilities of the
household, at one point in time. Household cash flow totals up all the
expected sources of income within a year, minus all expected
expenses within the same year. From this analysis, the financial
planner can determine to what degree and in what time the personal
goals can be accomplished. - Adequate protection: or insurance, the analysis of how to protect a
household from unforeseen risks. These risks can be divided into
liability, property, death, disability, health and long-term care. Some
of these risks may be self-insurable while most will require the
purchase of an insurance contract. Determining how much insurance
to get, at the most cost effective terms requires knowledge of the
market for personal insurance. Business owners, professionals,
athletes and entertainers require specialized insurance professionals to
PERSONAL FINANCE
adequately protect themselves. Since insurance also enjoys some tax
benefits, utilizing insurance investment products may be a critical
piece of the overall investment planning. - Tax planning: typically, the income tax is the single largest expense
in a household. Managing taxes is not a question whether or not taxes
will be paid, but when and how much. The government gives many
incentives in the form of tax deductions and credits, which can be used
to reduce the lifetime tax burden. Most modern governments use a
progressive tax. Typically, as one’s income grows, a higher marginal
rate of tax must be paid. Understanding how to take advantage of the
myriad tax breaks when planning one’s personal finances can make a
significant impact. - Investment and accumulation goals: planning how to accumulate
enough money for large purchases and life events is what most people
consider to be financial planning. Major reasons to accumulate assets
include, purchasing a house or car, starting a business, paying for
education expenses, and saving for retirement.
Achieving these goals requires projecting what they will cost, and
when one needs to withdraw funds. A major risk to the household in
achieving their accumulation goal is the rate of price increases over
time, or inflation. Using net present value calculators, the financial
planner will suggest a combination of asset earmarking and regular
savings to be invested in a variety of investments.
In order to overcome the rate of inflation, the investment portfolio has
to get a higher rate of return, which typically will subject the portfolio
to a number of risks. Managing these portfolio risks is most often
accomplished using asset allocation, which seeks to diversify
investment risk and opportunity. This asset allocation will prescribe a
percentage allocation to be invested in stocks, bonds, cash and
alternative investments. The allocation should also take into
consideration the personal risk profile of every investor, since risk
attitudes vary from person to person.
Depreciating Assets- One thing to consider with personal finance
and net worth goals is depreciating assets. A depreciating asset is an
asset that loses value over time or with use. A few examples would be
the vehicle that a person owns, boats, and capitalized expenses. They
add value to a person’s life but unlike other assets they do not make
money and should be a class of their own. In the business world, for
tax and bookkeeping purposes, these are depreciated over time due to
the fact that their useful life runs out. This is known as accumulated
depreciation and the asset will eventually need to be replaced.
PERSONAL FINANCE - Retirement planning is the process of understanding how much it
costs to live at retirement, and coming up with a plan to distribute
assets to meet any income shortfall. Methods for retirement plan
include taking advantage of government allowed structures to manage
tax liability including: individual (IRA) structures, or employer
sponsored retirement plans. - Estate planning involves planning for the disposition of one’s assets
after death. Typically, there is a tax due to the state or federal
government when one dies. Avoiding these taxes means that more of
one’s assets will be distributed to their heirs. One can leave their
assets to family, friends or charitable groups. - Delayed gratification: Delayed gratification, or deferred gratification
is the ability to resist the temptation for an immediate reward and wait
for a later reward. This is thought to be an important consideration in
the creation of personal wealth. - Cash Management: It is the soul of your financial planning, whether
you are an employee or planning your retirement. It is a must for
every financial planner to know how much he/she spends prior to
his/her retirement so that he/she can save a significant amount. This
analysis is a wake-up call as many of us are aware of our income but
very few actually track their expenses. - Revisiting Written Financial Plan Regularly: Make it a habit to
monitor your financial plan regularly. An annual review of your
financial planning with a professional keeps you well-positioned, and
informed about the required changes, if any, in your needs or life
circumstances. You should be well- prepared for all sudden curve balls
that life inevitably throws in your way. - Education Planning: With the growing interests on students’
loan, having a proper financial plan in place is crucial. Parents often
want to save for their kids but end up taking the wrong decisions,
which affect the savings adversely. We often observe that, many
parents give their kids expensive gifts, or unintentionally endanger the
opportunity to obtain the much-needed grant. Instead, one should
make their kids prepare for the future and support them financially in
their education.
Conclusion According to a survey done by Harris Interactive, 99% of the adults agreed
that personal finance should be taught in schools.[24] Financial authorities
and the American federal government had offered free educational materials
online to the public. However, according to a Bank of America poll, 42% of
adults were discouraged while 28% of adults thought that personal finance is
a difficult subject because of vast amount of information available online. As
of 2015, 17 out of 50 states in the United States require high school
students to study personal finance before graduation.[25][26] The
effectiveness of financial education on general audience is controversial. For
example, a study done by Bell, Gorin and Hogarth (2009) stated that those
who undergo financial education were more likely to use a formal spending
plan. Financially educated high school students are more likely to have a
savings account with regular savings, fewer overdrafts and more likely to
pay off their credit card balances. However, another study was done by Cole
and Shastry (Harvard Business School, 2009) found that there were no
differences in saving behaviours of people in American states with financial
literacy mandate enforced and the states without a literacy mandate
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