What is Personal Finance? Personal finance is the financial management that an individual or a family unit engages into the budget, save, and spend monetary resources over time, while taking into consideration various financial risks and future life events, among other things.
When it comes to personal finances, an individual would consider the suitability to his or her needs of a variety of banking products (checking, savings, credit, and consumer loans), investment in private equity (companies’ stocks, bonds, mutual funds), and insurance (life, health, and disability insurance) products, participation and monitoring of and- or employer-sponsored retirement plans, social security benefits, and income tax management when making financial plans.
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History of Personal Finance
Prior to the development of a specialty in personal finance, various disciplines that are closely related to it, such as family economics and consumer economics, were taught in various colleges as part of home economics for more than a century before the specialty was established.
Hazel Kyrk conducted the first known study on personal finance in 1920, which was published in the journal Personal Finance. Her dissertation at the University of Chicago laid the groundwork for consumer economics and family economics as we know them today. A professor of Home Economics at the same university, Margaret Reid is widely regarded as one of the world’s leading authorities on consumer and household behavior.
According to Herbert A. Simon, a Nobel Prize winner, a decision-ability maker’s to make the best financial decision was limited by his or her limited educational resources and personal inclinations when they made their decision in 1947. Dan Ariely asserted in 2009 that the 2008 financial crisis demonstrated that human beings do not always make rational financial decisions and that the market does not always self-regulate and correct for imbalances in the economy, and that the market does not always self-regulate and correct for imbalances in the economy.
As a result, personal finance education is required in order to assist an individual or a family in making rational financial decisions throughout their lives. Ordinary economists and business professors paid little attention to personal finance in the decades prior to 1990. But in the last 30 years, a number of American universities, including Brigham Young University, Iowa State University, and San Francisco State University, have begun to offer financial education programs to students in both undergraduate and graduate programs. Several of these institutions’ publications have appeared in peer-reviewed journals such as The Journal of Financial Counseling and Planning and The Journal of Personal Finance, among others. Research into personal finance is based on several theories such as social exchange theory and andragogy (adult learning theory) (adult learning theory). It was during the 1950s to 1970s that professional organizations such as The American Association of Family and Consumer Sciences and The American Council on Consumer Interests began to play an increasingly important role in the development of this field. Personal finance history was marked by the establishment in 1984 at Iowa State University of the Association for Financial Counseling and Planning Education (AFCPE), as well as the Academy of Financial Services (AFS), which both came into being in 1985. Faculty and recent graduates from business and home economics colleges make up the majority of those who attend the two societies’ meetings. Several certifications for professionals in this field have been developed since then, including the Accredited Financial Counselor (AFC) and the Certified Housing Counselor (CHC) (CHC). While this is happening, AFS collaborates with Certified Financial Planners (CFP Board).
As consumer concerns about their financial capability have grown in recent years, a variety of education programs have emerged, some of which are targeted at a broad audience, while others are targeted at specific groups of people, such as young people and women. The educational programs are commonly referred to as “financial literacy” programs. However, until the financial crisis of 2008, there was no standardized curriculum for personal finance education in the United States. The United States President’s Advisory Council on Financial Capability was established in 2008 with the goal of increasing financial literacy among the general public in the United States. It also emphasized the importance of establishing a standard in the field of financial education, as previously stated.
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Basic Principles of Personal Finance
Personal circumstances, such as patterns of income, wealth, and consumption needs, differ significantly from one person to the next. The taxation and finance laws differ from one country to the next, and market conditions vary geographically and over time. In other words, advice that is appropriate for one person may not be appropriate for someone else. Although a financial advisor can provide personalized advice in complicated situations and for high-net-worth individuals, University of Chicago professor Harold Pollack and personal finance writer Helaine Olen argue that in the United States, good personal finance advice boils down to a few simple points:
Although a financial advisor can provide personalized advice in complicated situations and for high-net-worth individuals, University of Chicago professor Harold Pollack and personal finance writer Helaine Olen argue that in the United States, good personal finance advice boils down to a few simple points:
- Pay off your credit card balance in full every month, with no exceptions.
- 20% of your income should be set aside for savings
- Establish an emergency fund.
- Contributions to tax-advantaged accounts, such as 401(k) retirement funds, individual retirement accounts, and 529 education savings plans, should be maximized whenever possible.
- When investing savings, Don’t try to trade individual securities on your own. Also Avoid mutual funds with high fees that are actively managed and Look for low-cost, diversified mutual funds that have a risk-to-reward ratio that is appropriate for the year you intend to reach retirement.
- If you hire a financial advisor, make sure they agree to a fiduciary duty to act in your best interests at all times.
The legal limitations imposed by each country may differ; in any case, personal finance should not be allowed to deviate from appropriate behavioral principles: people should not develop an attachment to the concept of money, which is morally reprehensible, and, when investing, they should maintain a medium-long-term horizon to avoid risks in the expected return on investment.
The planning process of Personal Finance
Personal financial planning is a dynamic process that necessitates ongoing evaluation and revision. Generally speaking, there are five steps to the process:
A person’s financial situation is assessed by compiling simplified versions of financial statements including balance sheets and income statements. Assets (e.g., automobile, home, clothing, stock portfolio) and liabilities (e.g., credit card debt, mortgage, etc.) are listed on a personal balance sheet (e.g., credit card debt, bank loan, mortgage). Expenses and income are listed in a personal financial statement.
2. Setting a goal
Short-term and long-term goals are common, as well as a mix of both. 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.” It’s easier to stay on track financially if you have goals in place. Setting financial goals is done in order to achieve a specific financial goal.
3. Developing a strategy
In order to achieve the objectives, a financial strategy is put in place. It could include, for example, slashing unnecessary costs, boosting wages, or investing in the stock market.
Discipline and perseverance are frequently needed when carrying out a financial strategy. Accountants, financial planners, investment advisors, and lawyers are just a few of the many professionals many people turn to for help.
5. Monitoring and reassessment
Aftersome time has passed, the financial plan is re-evaluated to see if any adjustments need to be made.
For most people, the most common financial goals they have are to pay off their credit card, student loan, mortgage, or car loan debt, invest in their future, and cover medical expenses.
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Why is Personal Finance so Important
The need for people to understand and be in control of their personal finances is extremely high right now. The following are some of the most important justifications for it:
1. Personal finance does not receive any formal education: Most countries provide formal education across a wide range of disciplines or areas of study. Individuals are motivated to learn in order to support themselves financially. It is through this pursuit that they will achieve tangible results in the form of money.
Even if we recognize that the aforementioned is a primary goal, there is no formal education at the elementary or secondary levels in schools or colleges to teach money management or personal finance.
As a result, it is critical to recognize the gap or disconnect in the educational system, where there is no formal way of preparing a person to manage his or her own finances.
This demonstrates the importance of learning personal finance from a young age in order to distinguish between needs and wants and to plan accordingly as one grows older.
2. Reduced employable age: It has been observed around the world over the years that several jobs that require manual intervention or that are mechanical in nature are increasingly becoming redundant as a result of the introduction of automation and changing needs.
There is a significant shift in employment opportunities from countries with higher labor costs to countries with lower labor costs, resulting in lower profit margins for businesses.
Employees in middle management who have not up-skilled are easily replaceable by new and fresh talent who are both less expensive and more valuable to the organizations in economies with a disproportionately large younger population entering the workforce and who are better equipped with cutting-edge technologies.
Consumer and business demand are driven by the health of a country’s economy in several industries such as automobile, chemicals, and construction; consumption and demand are driven by the health of a country’s economy. Several studies have found that when economies stagnate, enter a period of recession, or enter a period of war, certain industries suffer more than others. The result is that businesses reduce the size of their workforce. An individual can lose his or her job with relative ease and remain unemployed for an extended period of time. All of these considerations lead to the realization that the legal employable age of 60 is gradually and steadily being pushed lower and lower.
Among the many reasons why individuals should begin planning for their retirement and systematically building their retirement corpus is the need for personal finance, which is discussed further below.
3. Increased life expectancy: As a result of advancements in healthcare, people today are living much longer lives than their forefathers. The average life expectancy has increased over the years, and people in developing countries are living for significantly longer periods of time. The average life expectancy has gradually increased from 60 years to 81 years and higher in recent decades. Because of increased life expectancy, combined with a shorter employable age, it is even more critical to have a large enough retirement fund and to understand the importance of personal financial planning.
4. Increasing medical expenses: Medical expenses, such as the cost of drugs, hospital admission care and charges, nursing care, specialized care, and geriatric care, have all seen an exponential increase in recent years, particularly in the United States. Many of these medical expenses are not covered by insurance policies, which may be provided by private/individual insurance coverage or by federal or national insurance coverage, depending on the situation.
In developed markets such as the United States, insurance coverage is provided by either employer, private insurers, or the government at the federal level (Medicare, primarily for senior citizens, or Medicaid, primarily for individuals of lower-income levels). However, given the growing fiscal deficit in the United States and the large proportion of the geriatric population, it is necessary to determine the extent to which the Medicare program will be financially sustainable in the long run. Therapy exclusions in the coverage, co-pays, and deductibles are just a few of the costs that will be borne by individuals on an ongoing basis.
In other developed markets, such as the European Union, the majority of medical care is reimbursed at the national level. Consequently, national healthcare budgets are extremely tightly controlled as a result of this. Many newer therapies, which are often more expensive, are often excluded from national formularies due to cost concerns. This means that patients may not be able to obtain these medications through the government’s policy and may be required to pay for them out of their own pockets.
Because there is no overarching government social security system that covers medical expenses in developing countries such as India and China, the majority of medical expenses are paid out of pocket.
These reasons demonstrate the importance of having a medical, accidental, critical illness, and life coverage insurance for oneself and one’s family, as well as the importance of having an emergency fund, which translates into the enormous need for personal finance and financial planning.
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Major Areas of Personal Financial Planning
According to the Financial Planning Standards Board, the following are the most important aspects of personal financial planning:
Financial position is concerned with gaining an understanding of one’s own personal resources by examining one’s net worth and one’s family’s cash flow. When a person’s net worth is calculated at a particular point in time, it is calculated by adding all assets under that person’s control and subtracting all liabilities from the household’s total liabilities. Household cash flow is the sum of all expected sources of income within a year, minus all expected expenses within the same year, calculated as follows: The financial planner can then determine to what extent and in what time frame the personal goals can be achieved based on the results of the analysis.
Adequate protection, also known as insurance, is the process of determining how to protect a household from unforeseeable dangers. Liability risks, property risks, death risks, disability risks, health risks, and long-term care risks are all categories of risk. Some of these risks may be self-insurable, whereas the majority will necessitate the purchase of an insurance contract to protect against them. Personal insurance market knowledge is required in order to determine how much insurance to purchase at the most cost-effective terms. A specialized insurance professional is required by business owners, professionals, athletes, and entertainers to ensure that they are adequately protected against risk. Insurance investment products may be a critical component of overall investment planning due to the fact that they provide tax benefits as well as financial protection.
Tax planning is important because, in most cases, income tax is the single most expensive item in a household’s budget. When it comes to tax management, it is not a question of whether or not taxes will be paid, but rather when and how much will be paid. There are numerous tax breaks and credits available from the federal government, which can be used to reduce one’s overall tax burden over one’s lifetime. Progressive taxation is used by the majority of modern governments. Most of the time, as one’s income rises, one’s marginal rate of taxation must rise as well. Understanding how to take advantage of the numerous tax breaks available when planning one’s personal finances can have a significant impact on one’s overall financial situation.
Investment and accumulation objectives
Most people consider financial planning to be the process of determining how to save and invest money in order to accumulate enough money for large purchases and life events. The purchase of a home or car, the start-up of a business, the payment of education expenses, and the accumulation of assets are all important reasons to accumulate assets.
To achieve these objectives, it is necessary to estimate how much they will cost and when it will be necessary to withdraw funds. The rate of price increases over time, also known as inflation, is a significant risk to the household’s ability to achieve its accumulation goal. Using net present value calculators, the financial planner will recommend a combination of asset earmarking and regular savings, which will be invested in a variety of different investments to achieve the best results. It is necessary for an investment portfolio to earn a higher rate of return in order to outpace the rate of inflation; however, this will typically expose the portfolio to a variety of risks. Asset allocation, which seeks to diversify investment risk and opportunity, is the most common method of reducing these portfolio risks and increasing returns. This asset allocation will specify a percentage allocation that will be invested in stocks, bonds, cash, and alternative investments, among other things. The allocation should also take into account the individual risk profile of each investor, because risk attitudes differ from one person to the next, as previously stated.
Depreciating Assets- When it comes to personal finance and net worth goals, depreciating assets should be taken into consideration. A depreciating asset is an asset whose value diminishes over time or as a result of its use. Vehicles, boats, and capitalized expenses are just a few examples of what is meant by capitalized expenses. However, unlike other assets, they do not generate income and should therefore be classified as a separate class of asset from the rest of the world. When it comes to the business world, these are depreciated over time for tax and bookkeeping purposes due to the fact that their useful life has come to an end. This is referred to as accumulated depreciation, and the asset will need to be replaced at some point in the future.
Understanding how much it will cost to live in retirement and devising a strategy for distributing assets to cover any income shortfall are the two main components of the process of retirement planning. Utilizing government-approved structures to manage tax liability, such as individual retirement accounts (IRAs) or employer-sponsored pension plans, are examples of retirement plan strategies.
Estate planning is the process of making arrangements for the distribution of one’s assets after death. When someone passes away, the state or federal government is usually obligated to collect a tax from the estate. Avoiding these taxes results in a greater proportion of one’s assets being distributed to one’s heirs. A person’s assets can be left to family, friends, or charitable organizations.
Delayed gratification (also known as deferred gratification) is the ability to resist the temptation of an immediate reward in order to wait for a later reward to occur. This is considered to be a significant factor in the accumulation of personal wealth by many people.
Whatever your financial situation, whether you are an employee or preparing for retirement, cash management is essential to your overall financial planning. Prior to retirement, it is essential for every financial planner to understand how much money he or she spends so that he or she can begin saving a significant amount of money. This analysis serves as a wake-up call, as many of us are aware of our income, but only a small percentage of the population actually tracks their expenses.
Revisiting Written Financial Plan Regularly
Regularly reviewing your written financial plan: Make it a habit to review your written financial plan on a regular basis. Having a professional review of your financial planning on an annual basis ensures that you are well-positioned and aware of any changes that may be required due to changes in your needs or life circumstances. You should be well-prepared for all the sudden curve balls that life inevitably throws in your way.
With the rising interest rates on student loans, having a solid financial plan in place is essential for achieving your educational goals. Parents frequently want to save for their children, but they end up making poor decisions that have a negative impact on their savings. We frequently observe that many parents give their children expensive gifts, or unintentionally jeopardize their chances of receiving a much-needed grant, without realizing it. Instead, parents should encourage their children to plan for the future and provide financial assistance to them as they pursue their education.