Introduction to Financial Decision-Making
L ECTURE 4
Professor Michael J. Boskin
Outline of Topics
• The Primary Components of Wise Money
Management
• Balance Sheets and Net Worth
• Cash Flow Statements
• Personal Budgets
• Money Management & Savings
• Financial Advisors
• What Can Go Wrong and Right and Why?
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A Successful Money Management Plan
• Money management refers to the day-to-day
financial activities necessary to manage current
personal economic resources, while working
toward long-term financial security.
• Daily spending and saving decisions are central to
financial planning.
› Must be coordinated with needs, goals, and personal
situations
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Components of Money Management
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Components of Money Management,
• Personal financial records and documents help
you plan the use of your resources.
› Provide written evidence of business transactions,
ownership of property, and legal matters
• Personal financial statements measure and
guide your financial position and progress.
• Your spending plan, or budget, is the basis for
effective money management.
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A System for Personal Financial Records
• Provides a basis for:
› Handling daily business affairs, such as bill
paying
› Planning and measuring financial progress
› Completing required tax reports
› Making effective investment decisions
› Determining available resources for current
and future buying
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Records in Your Home File
• Items you refer to often, including:
› Personal and employment records (offer letters, payroll
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stubs, performance reviews, etc.)
Money management and financial services records
(brokerage statements, bank statements, other)
Tax records (tax returns, receipts, W2/1099/K1 forms, etc.)
Credit records (credit card statements, loan documents, etc.)
Consumer purchase and auto records (receipts, warranties,
manuals, title documents)
Housing records (property titles, mortgage documents,
property tax information, etc.)
Estate planning and retirement records (wills, trusts,
statements, etc.)
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How Long Should Records be Kept?
Records
Retention Period
Birth certificates, wills, and Social Security
information
Permanently
Personal property and investments
As long as you own them
Documents re: purchase and sale of real estate
Indefinitely
Copies of tax returns and supporting data
3 or 7 years, or indefinitely
for property, until disposed
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What to Keep in a Safe Deposit Box or
Fireproof Home Safe
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Birth, marriage, and death certificates
Citizenship papers
Adoption, custody papers
Military papers
• Serial numbers of expensive items
• Photographs or video of valuable belongings
• Certificates of deposit
• List of checking and saving account numbers and
financial institutions
• Credit contacts
• List of credit card numbers and telephone
numbers of issuers
• Mortgage papers, title deed
• Automobile title
• List of insurance policy numbers and company
names
• Annual stock and bond statements
• Rare coins, stamps, gems, and other collectibles
• Copy of will
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Keeping Computer Records Safe:
Hacking and Identity Theft Are Becoming Common
• As more documents are provided electronically and
people are storing financial records “in the cloud,”
consider the following actions:
• Download copies of all statements and forms to local
storage and use logical filenames and folders.
• Back up files externally or online.
• Secure data with complex passwords or encryption!
• Scan copies of documents.
› Hard copies of some documents may be required, proof
of COVID vaccination may be required, e.g. to enter a
country
• Completely erase files.
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Records on Your Personal Computer
• Current and past budgets
• Summary of checks written and other banking
transactions
• Past income tax returns
• Account summaries, performance results of
investments
• Digital versions of wills, estate plans, and
other documents
* Keep a backup!
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What NOT to Keep and What to Shred
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Personal Financial Statements
• The main purposes of personal financial statements are to:
1. Report your current financial position
2. Measure your progress toward financial
goals
3. Maintain information about your financial
activities
4. Provide data for preparing tax forms or
applying for credit
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Your Personal Balance Sheet:
The Starting Point
• A balance sheet is a financial statement that reports what
an individual or family owns and owes as of a specific
date (snapshot in time.) Same is true for a business.
• Also called:
› Net worth statement
› Statement of financial position
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Creating a Personal Balance Sheet
• Step 1 – List items of value
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Liquid assets
Real estate
Personal possessions
Investment assets
• Step 2 – Determine amounts owed
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Current liabilities (liabilities = amounts owed to others)
Debts that must be paid within a short time, usually a year
Long term liabilities
Debts that are not required to be paid in full for more than a year
• Step 3 - Compute your net worth
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Net Worth, Assets, and Insolvency
Assets - Liabilities = Net Worth
• Measurement of current financial position
• Net worth ≠ cash available
• The amount you would have left if all assets were sold for
their values and all debts were paid in full (Mark to market?)
Assets = Liabilities + Net worth
• Insolvency:
› Inability to pay debts when due
› Liabilities far exceed assets
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Equations
• Income = Saving + Consumption
Y=S+C
or
S=Y-C
• Net assets (assets (A) – liabilities (L)), or net worth (NW),
evolves over time based on 4 factors: Your initial net
worth, the rate of return on your assets (minus fees,
commissions, taxes, and inflation), your initial liabilities
and any interest charges thereon, and your new saving, S.
Recall that if you are borrowing more than you are
positively saving, S is negative, and that paying down debt
balances is new saving
NW 𝑡 = 𝐴 𝑡 − 𝐿 𝑡 = 𝐴 𝑡 − 1 ∗ 1 + 𝑟 −
𝐿 𝑡 − 1 ∗ (1 + 𝑖) + 𝑆
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Ways to Increase Net Worth
• Increase saving by reducing spending or
increasing income
• Reduce spending
• Increase the value of investments and other
possessions
• But make sure to account for risk
• Reduce amounts owed
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Ways to Decrease Net Worth
• Decrease savings by increasing spending
or reducing income
• Increase spending
• Decrease the value of investments and
other possessions
• Increase amounts owed
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The Cash Flow Statement
• Cash flow is the actual inflow and outflow of cash during
a given time period. What is cash? Cash equivalents?
• Cash flow statement is also known as a personal income
and expenditure statement. Same is true for a business.
› Summary of cash receipts and payments for a given period
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The Cash Flow Statement
Inflows and Outflows
• Inflows are deposits made into your
account(s).
• Outflows include:
› Checks written
› Cash withdrawals
› Debit card payments, or other means of
payments
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Creating a Cash Flow Statement
• Step 1 – Record Income
• Income is the the inflows of cash for an individual or a
household.
› Take-home, or net pay, is earnings after deductions for taxes
and other items; also called disposable income.
› Commissions, self-employment income, interest, dividends,
gifts, grants, scholarships, government payments, pensions,
retirement income, alimony, and child support, etc.
› Discretionary income is money left over after paying for
housing, food, and other necessities.
• Step 2 – Record cash outflows
› Fixed and variable expenses
• Step 3 – Determine Net Cash Flow
› Use this statement as a basis for creating a spending, saving
and investment plan.
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Sample Cash Flow Statement
Stanford 2021 Graduate
Cashflow statement for the month ending 2022
Income (Cash inflows)
• Gross Salary:
• Less deductions
• Federal income tax:
• State income tax:
• Social security tax:
• Total deductions: $1,772
• Balance:
• Other recurring income
(Interest, Dividends):
• Total Income:
Cash Outflows
• Fixed expenses
• Rent:
• Cable/Internet:
• Monthly commute
(train ticket,
FastTrack):
• Insurance: $100
• Total fixed outflows:
$6,000
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$1,000
$400
$372
$4,228
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Variable expenses
• Food:
• Utilities, phone, electricity etc.:
$100
• Personal care, laundry dry-cleaning:
• Medical (copays, deductibles):
$100
• Recreation, entertainment, other: $300
Total variable outflows:
$1,050
Total outflows:
Cash surplus + (or deficit -):
$500
$50
$3,360
+$968
$100
$4,328
$2,000
$60
$150
$2,310
Allocation of Surplus
• Emergency fund savings:
• Savings for short-term/intermediate
term financial goals:
• Saving/investing for long-term
financial security:
$568
• Total surplus:
$968
$250
$150
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A Plan for Effective Budgeting
• Budget, or spending plan, is necessary for successful
financial planning.
• Helps you:
› Live within your income
› Spend money wisely
› Reach financial goals
› Prepare for financial emergencies
› Develop wise financial management habits
› Also applies to businesses and non-profits
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Developing a Monthly Budget
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Step 1: Set Financial Goals
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Step 2: Estimate Income
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Step 3: Budget an Emergency Fund and Savings
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Step 4: Budget Fixed Expenses
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Step 5: Budget Variable Expenses
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Step 6: Record Spending Amounts
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Step 7: Review Spending and Saving Patterns
› Review financial progress
› Revise goals and budget allocations
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National Household Balance Sheet Q4 2021
($ billions)
Assets:
Major categories:
Real estate
Consumer durable goods
Checkable deposits
Time and savings deposits
Money market fund shares
U.S. government and
municipal securities
Corporate and foreign bonds
Corporate equities
and mutual fund shares
Pension entitlements
Equity in noncorporate business
Miscellaneous assets
$159,621.8
$38,105.5
$7,287.7
$3,887.5
$10,837.7
$2,739.6
$2,558.5
$242.6
$42,572.9
$31,751.9
$15,125.1
$1,420.2
Liabilities:
Major categories:
Home mortgages
Consumer credit
Net worth
$17,437.2
$11,742.5
$4,434.4
$142,182.1
Source: Federal Reserve
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Characteristics of a Successful Budget
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Well-planned, organized, internally consistent
Realistic assumptions (what is the basis?)
Flexible, a guide/compass to be followed, not a straitjacket
Clearly communicated, whatever method you choose
Mental Budget
› Appropriate if financial resources and responsibilities are limited
• Physical Budget
› Envelopes, folders, or containers
• Written Budget
› On paper (ex. notebook or multicolumn accounting paper)
• Computerized Budget
› Spreadsheet or specialized software
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Money Management and Achieving Financial
Goals
• Your Balance Sheet:
› Snapshot of where you are now
• Your Cash Flow Statement:
› What you received and spent over a specific
period
• Your Budget:
› Planning spending and saving to achieve
financial goals
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Calculating Savings Amounts/ Targets
• Convert savings goals into specific amounts.
• Use savings and investments plans to grow your
assets.
• Use time value of money to calculate progress
toward financial goals.
• Account for expected earnings growth, inflation
and taxes
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Financial Advice
• Software, apps can help you keep track of things (but
won’t change your behavior) – budget categories,
spending patterns, tax records, expenses, growth potential
of savings and investments, market value of investments,
home inventory items, projecting insurance and retirement
needs
• Publications – WSJ, Consumer Reports, Forbes, Fortune,
Bloomberg Personal Finance, Yahoo Finance, guru blogs,
financial institutions. Keep up to date.
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Financial Planning Specialists
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Accountants /other tax preparers– tax and personal financial
statements
Bankers – financial services and trusts
Certified Financial Planners – help you coordinate decisions into a
plan
Credit counselors – suggest ways to reduce spending and eliminate
credit problems
Insurance agents – sell insurance to protect your wealth and property
Investment brokers – provide information and handle stock/bond/other
investment transactions
Lawyers – help prepare wills, estate plans, trusts, and handle other
legal matters
Real estate agents – assist with buying/selling homes and other real
estate
These can overlap, of course
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Financial Planning Specialists
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Hundreds of thousands of people call themselves financial planners..
Be cautious.
Fee-only planners
› Hourly rate and/or fixed fee, or possibly an annual fee as a % of the
value of your assets (usually 1/2—1%)
Fee-offset planners
› Start with hourly or annual fee, and is reduced by commission
earned from sale of investments or insurance
Fee-and-commission planners
› Earn commission from investments and insurance products
purchased and charge a fixed fee for a financial plan.
Commission-only planners
› Earn solely commission on sales of insurance, mutual funds, other
investments, etc.
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Picking a Financial Advisor
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Do you need one? Probably depends on magnitude and complexity of
your income and assets and situation and also your willingness to
make independent decisions
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How up on things are you willing to stay? To what degree? This
means time and effort and focus
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Maybe it’s a mixed approach
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How do you find what you need? References from people you trust
(personal, business, etc.)
• Cross-check carefully
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Fiduciary duties
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Fees
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Picking a Financial Advisor:
Questions you might ask…
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Is financial planning all you do? What else?
Are you licensed or certified in any way? Seller of Insurance?
Investment brokerage? Education background and formal training?
CPA, JD, CFP, CFA (Chartered Financial Analyst), RIA (Registered
Investment Advisor)
Areas of expertise? Do you consult other experts in other areas
(taxes, insurance, etc.) to help you formulate advice?
Free consultation?
Fees and how determined? May I see your contract for clients?
Independent or affiliated with a major financial services company?
References to current and past clients?
Sample recommendations?
My major concern is ___. What would you suggest?
Are you a FIDUCIARY?
Note: Mix of state and Federal regulation and oversight
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So Where Can It All Go Right or Wrong?
Reminder: Ways to Increase/Decrease Net Worth
• Increase/Decrease savings, by
decrease/increase spending and/or
increase/decrease income
• Increase/Decrease spending
• Increase/Decrease the value of investments
and other possessions
• But make sure to account for risk
• Increase/Decrease amounts owed
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So Where Can It All Go Wrong/Right?
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Lack of knowledge/Become knowledgeable
Irrational, internally inconsistent choices/ tools for consistency
Psychological
› Procrastination in developing a plan; ostrich effect: avoid discomfort and anxiety
› SPENDING: Bandwagon effect etc.; post-purchase rationalization, denomination
effect, careful use of credit
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› SAVING: impulse buys and instant gratification, savings automation and selfcontrol
› INVESTING: Professor Shoven and I will discuss these more later- loss aversion,
hindsight bias, confirmation bias; regular habits and periodic evaluation
Interpersonal Relationships: People, Families, Habits
› Gambling
› Divorce
› Trusting the wrong people/ fraud
› Emotional lending
› Celebrities in entertainment and sports get the most attention, as the examples
discussed in the breakout session noted, but versions of this happen all of the time.
To many people and even sometimes to the highly educated
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Where Can It All Go Wrong?
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Where Can It All Go Wrong?
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Where Can It All Go Wrong?
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Conclusion
• Wise management of your resources, including your human
capital, investments, and credit, begins with setting your financial
goals and using, keeping track of, and understanding your
personal financial statements.
• These include your balance sheet, cash flow statement, and
budget.
• As you your earnings and net worth begin to grow, you will need to
keep track of, and safely store and maintain, financial records.
• You will likely interact with a variety of finance and tax professionals
soliciting your business.
• Even if you decided to manage your finances yourself, you will
still need some financial services.
• There are many software tools that can make your record
keeping, tax payments, etc. easier.
• If you use a financial advisor, choose wisely after cross checking
references, understanding any conflicts and fees you may be
charged, and ascertaining if such charges are worth paying.
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