Twelve Key Elements of
Practical Personal
Finance
Common Sense Economics
James Gwartney, Richard L. Stroup,
and Dwight R. Lee
CommonSenseEconomics.com
CommonSenseEconomics.com
1
Why Is There Financial
Insecurity in America?

Do You Think It Is Because Incomes Are
Low?

See next slide.
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2
U.S. Income Is Rising and Has
Never Been Higher
Real Disposable Income Per Capita
35000
Billions of 2000 Chained Dollars
30000
25000
20000
15000
10000
5000
0
1970
1975
1980
1985
1990
1995
CommonSenseEconomics.com
2000
2005
3
Consumption Per Person Is
Also Growing
Real Disposible and Consumption Per Capita
30000
Billions of 2000 Chained Dollars
25000
20000
15000
10000
5000
0
1970
1975
1980
1985
1990
1995
2000
2005
Year
CommonSenseEconomics.com
Real Personal Disposible Income Per Capita (2000 Dollars)
Real Personal Consumption Per Capita (2000 dollars)
4
Financial Insecurity:


Let’s take a look at how households divide
their income between consumption and
savings.
Remember, saving helps households prepare
for surprise expenditures.
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U.S. Saving Rates Are Falling While
Consumption Rates Are Rising …
As a Percentage of Real Disposable Income
100%
90%
80%
70%
60%
50%
40%
30%
20%
10%
0%
1970
1975
1980
1985
1990
1995
2000
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Savings Rate
Consumption Rates
2005
6
And Interest on Household Debt
as a Percentage of Income
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2007 SA dollars
Real Consumer Credit Outstanding Per
Household
22,000
21,000
20,000
19,000
18,000
17,000
16,000
15,000
14,000
13,000
12,000
11,000
10,000
9,000
1970
1975
1980
1985
1990
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1995
2000
2005
8
Revolving Debt as a % of Total Consumer Credit
50.00%
45.00%
40.00%
Percentage
35.00%
30.00%
25.00%
20.00%
15.00%
10.00%
5.00%
0.00%
1970
1975
1980
1985
1990
1995
2000
2005
Year
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Real Unpaid Credit Card Balance Per U.S. Household
(2007 Dollars)
$10,000
$8,000
$6,000
$4,000
$2,000
$0
1970
1975
1980
1985
1990
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1995
2000
2005
10
Summarizing Trends in
Household Finance

While real income per person is rising,




The savings rate is falling, and
Debt is increasing.
A failure to save regularly, use credit cards
prudently, consume wisely and invest
strategically are largely responsible for financial
insecurity in America.
These trends highlight why it is important to get
control of your finances before they get control
of you.
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Planning to Achieve Financial
Security

Set financial goals for the short and long
run.
 Put plans in place to achieve these
goals.
 Work hard and work smart.
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Why Do We Need or Want
Financial Security?
Financial security will help us
live less stressful lives and
pursue other goals
Less Conflict in Marriage
Better Health
Family
Religious Goals
Education
Retirement
Charitable Contributions
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“If you don't know where you
are going, you might wind up
someplace else.”
~ Yogi Berra
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Practical Element of
Personal Finance #1
Discover your comparative
advantage.
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Comparative Advantage





Discover what you can produce at a lower cost than
others. Think opportunity costs!
Find out what others value and know how much they
are willing to pay you to produce your low cost good
or service.
Trade your valuable services and goods for income.
Use that income to buy those goods that would be
expensive for you to produce and save to achieve
other financial goals.
Exchange is mutually advantageous! Consider the
scenario presented in the next slide.
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Farmer John vs. Nurse Kelly: Can
They Gain From Specialization
and Trade?
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What’s Your Comparative
Advantage?


Think about what you are good
at doing and enjoy. Is this
something others’ value highly?
How do you know?
Is your educational training
helping you develop a
comparative advantage?
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Practical Element of
Personal Finance #2
Be entrepreneurial.
In a market economy, people maximize
their income by providing services and
goods others value. They get ahead by
discovering better ways of doing things in
and outside their workplaces.
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The Entrepreneur Next Door



Entrepreneurs actively
pursue discovering
better ways of doing
things.
They act quickly and
strategically on new
opportunities.
Entrepreneurs fuel
economic growth and
development!
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Entrepreneurs’ Success:
Entrepreneurial talent: the ability to discover
1.
a.
b.
c.
2.
new products that are highly valued relative to costs,
cost-reducing production methods, and
profitable opportunities that others overlook.
Tolerance for risk: Entrepreneurial activity and
self-employment are riskier than being employed
by a proprietor, partnership or corporation. But
greater risk can translate into higher income and
more wealth.
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Entrepreneurs’ Success (cont.)
3.
High Savings Rates: Entrepreneurs have
high savings rates. Often they invest in
their businesses, adding to their wealth.
4.
Work Hard and Smart: Entrepreneurs,
business owners and independent
contractors tend to work longer hours and
more strategically.
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Practical Element of
Personal Finance #3
Spend Less Than You Earn
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Why Should You Save?
•
•
•
Increase your wealth.
Live a less stressful,
more financially free
life.
Achieve high
consumption levels in
the future.
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How Do You Start?




Just do it.
Make savings a part of your
monthly plans, e.g. channel a
designated amount into an
electronic savings account.
Develop a budget and figure
out how to reduce
discretionary spending.
Buy used or sale items and
place the “savings” into an
account.
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Just Do It!!!



Exert the willpower to save now.
It is unlikely that you will do so later.
If you wait to save until your income goes up, it will
be extremely costly in terms of the funds available at
retirement.
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Coffee Anyone?
Many people buy one premium cup of
coffee each day. Assume each cup costs
$4. If they could earn a 7% return, how
much could this “coffee” money earn over a
50 year period if saved or invested?

a.
b.
c.
d.
Nothing. The coffee is consumed!
$1,460
$73,000
$ 443,918
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Strategic Savings

Tax deferred savings.



Automatically deduct savings from your gross income, thereby
reducing your taxable net income.
There are many types of tax-deferred savings plans: traditional
IRAs, 401(k) plans, 403(b) plans, etc.
Think of creative ways to spend less.




Use coupons and allocate savings into an account.
Strategically purchase used items.
Shop when there are bargain sales and promotions.
Budget, budget and budget. Spend less and save more.
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Practical Element of
Personal Finance #4
Don’t finance anything for
longer than its useful life.
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Financing Consumption


Purchase on credit only
when you are buying
revenue generating assets
in order to earn positive net
returns.
Financing makes it possible
for you to spend now and
pay later. Don’t build up
debt unless it is strategic!
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Good Debt. When can you
finance?
When goods and services financed
now promise to yield a return
greater than cost (principal and
interest).


Residential home
Education
Under certain circumstances, these assets
generate income and wealth over time.
They can help increase your net worth
(assets less liabilities).
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What Should Not Be Financed?

Nondurables – Goods that are consumed or
items that lose their value quickly.

Once consumed, food, clothing and concerts are
gone. Payments will linger if not paid for when
purchased.
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Practical Element of
Personal Finance #5
Get More Out of Your
Money
1. Avoid credit card debt.
2. Consider purchasing
used items.
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Paint a Bright Future!!!



Save today and spend in the future!
Use credit cards wisely and pay them off immediately.
Build a strong credit history in order to get the best interest
rates when financing a house, car and other big ticket
items.
“…ordinary people can have lots of nice things
and still accumulate a lot of money.”
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Credit Card Convenience

Paying with a credit card is NOT
spending your own money, but
borrowing someone else’s IF you do
not pay right away.

Interest rates on credit cards are high
because they are unsecured. Interest
charges will outstrip what you can earn
on savings and investments.

Think of your credit card as an
extension of your checking
account…Always pay your credit card
bill in full.
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You paid how much?


You buy new clothes, go to a once-in-a-life-time
concert with friends and buy more and more until
you gradually hit your credit limit of $2000 at 13.4%.
You can only manage to pay the minimum of $50
each month.
How many months will it take you to pay the credit
card off?



40, 80, 120, or 166 months?
166 months!
How much does the $2000 end up costing you in
interest?


$0, $130.40, about $260, over $1300?
CommonSenseEconomics.com
$1300 in interest! And the items costing $2000 are gone!
36
Buy Used
When Strategic




Is buying new worth it?
Depreciation costs make new cars
expensive. They depreciate substantially
when driven off the lot and they depreciate
rapidly in the first three years.
Used cars may have slightly higher
maintenance costs but their depreciation
costs are much lower.
Buy used! Visit Edmunds.com and compare.
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Do Credit Card Companies Prey
on the Financially Illiterate and
Undisciplined?


Advertisement of a credit card company:
“You want it all, and you want it now! Our
credit card will make it possible.”
Is this a lie?


Are goods scarce? Can we have everything?
How will going deeper into debt affect your wealth
and future consumption?
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Do Credit Card Companies
Think You Are Suckers?







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to 6 months
No annual fee
Earn 15 Karma Points just by getting approved for a Chase credit
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the Chase +1 store
Why do you think you get so
many applications?
CommonSenseEconomics.com
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Practical Element of
Personal Finance #6
Pay into a “real-world”
savings account every
month.
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Rainy Days & the Real World

Life is full of “surprises”, and
they’re usually expensive!

Cars break down.

Heaters and air
conditioners go.

People get sick or
injured.
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Plan For Your Rainy Days!



The only “surprise” is
the timing. So put a
plan in place!
Purchase “peace of
mind” by building a
savings cushion.
Make contributions
regularly and a
mandatory part of your
monthly budget!
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Practical Element of
Personal Finance #7
Put the power of
compound interest
to work for you.
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It’s a Miracle!!!


Save and invest
regularly. There is a
huge payoff!
Compound interest
allows you to earn
more and more
interest on interest
and your investment!
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The Rule of 70

Determine how long it takes to double your
investment.


Place funds in an investment and let it grow over
time.
Divide 70 by the expected rate of return (R) and
see how long it takes to double in size.
70 = Number of years
R
to double

When R = 7%, your investment will double in?

10 years (=70/7)
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Take A Closer Look

Save $2000 at the age of 16 and place it in an
investment that promises a 10 percent return.

How long will it take you to generate $4000 in funds?



7 years (70/10)
So at the age of 23 you will have $4000.
How much will you have at the age of 30 if you continue to
invest the funds?

$8,000 ($4000 + $4000)

Age 37?

$16,000
Age 51?
 $64,000 ($16,000 + $16,000 + $32,000)

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Practical Element of
Personal Finance #8
Diversify - don’t put all of your
eggs in one basket.
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Accumulate Wealth and Gain
Financial Security




Investments involve risk, especially in the short-run.
Manage this risk by building a broad portfolio based
on diversification.
Historically, long term returns on stocks have been
attractive. But diversification is essential.
Hold a large number of unrelated stocks for a
lengthy period of time. Put the law of large numbers
to work for you!
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The Law of Large Numbers
The law of large numbers states that while some of the
investments in a diversified portfolio will do poorly,
others will do well.


The performance of the latter will offset that of the former,
and
The rate of return will converge toward the historic
average.
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Avoid Double Jeopardy




Does your employer offer a company stock-based
retirement program or agree to match any income used
to purchase company stock if held for a period of time?
IF your company is well established and has solid growth
potential, consider this investment opportunity.
However, sell your company shares and diversify as
soon as permitted.
Failure to do so puts you in double jeopardy …You are
now beholden to your company both for current
employment and retirement income. If your company
fails, you lose both. Diversify!
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Practical Element of
Personal Finance #9
Indexed equity funds
can help you beat the
experts without taking
excessive risk.
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The Random Walk Theory

No one person, group of experts, or
company can predict future changes in
the stock market.

The random walk theory suggests
 Current stock prices reflect all
information about the company.
 Unforeseeable events drive
changes in stock prices.

Since future changes are driven by
unforeseen events, no one can “beat
the market”.
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Mutual Funds

Mutual Funds


A mutual fund pools the savings of many
individuals and channels them into alternative
investments.
There are many types of mutual funds – money
markets, bonds, and equity fund mutual funds.
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Two Types of Equity Funds


Managed equity funds are administered by
professionals, seeking to pick and choose
stocks. A large research staff is often
involved.
Indexed equity funds are invested to reflect
the holdings of broad indexes such as the
Dow Jones Industrials, S&P 500 Composite
Stock Price Index, the Russell 2000 Index, or
the Wilshire 5000 Total Market Index.
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Indexed Equity Funds vs.
Managed Funds

Because their holdings simply mirror a broad index,
indexed equity funds do not require a lot of





Market research
Stock trading
Consequently, the administrative costs of indexed
equity funds are lower than funds managed by
professionals.
Thus, more of your funds are channeled into
investments.
Historically, the average long-term yield of indexed
equity funds has been higher than their managed
counterparts.
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Practical Element of
Practical Personal
Finance #10
Invest in stocks for long-run
objectives;
as the need for money
approaches, increase the
proportion of bonds.
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Hold On




You have built a diversified
portfolio and set long-term
financial goals.
You channel savings to cover
unexpected expenditures.
Volatile times in financial
markets will emerge. Ride it
out. In the long-run stocks
rebound and you are covered.
So avoid selling stocks when
the market is “bearish”.
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Stocks vs. Bonds




Historically, the real return from
stocks (about 7%) has been
higher than for bonds (about 3%).
The stock market is volatile.
Therefore, holding stocks is risky
when you may need the funds in
the near future.
Bonds yield a set nominal return.
When funds are needed in five
years or less, they will be less
risky than stocks.
Nonetheless, bonds involve risk.
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Bonds: Two Main Types of Risks

Inflation risk: Unexpected inflation erodes the
purchasing power of the face value of the
bond and the interest earned.


Treasury Inflation Protected Securities (TIPS)
help protect against this risk.
Interest rate risk: Unexpected increases in
the interest rate reduce the value of
outstanding bonds.

This risk increases with the length of time to
maturity.
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Bond Investment Strategies


Buy bonds that mature when funds will be
needed. If you need funds in five years, buy a
five year bond.
Transfer funds in a diversified portfolio gradually
from stocks to bonds as funds will be needed in
retirement, thus reducing your vulnerability to
volatile changes in the stock market.
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Practical Element of
Personal Finance #11
Beware of investment
schemes promising high
returns with little or no
risk.
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There’s no such thing as a free
lunch!!!


Beware of deals that sound too
good to be true!
The principal-agent problem
makes you vulnerable.


A potential conflict of interest
exists between the investor and
the agent selling investment
products.
The agent seeks to profit and has
more information about the
product than the investor. The
investor is at a disadvantage and
should be skeptical.
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Tips for Avoiding Investment Fraud
1.
2.
3.
4.
5.
6.
If it looks too good to be true, it probably is.
Deal only with parties that have a reputation to
protect.
Never purchase an investment solicited by
telephone or email.
Do not allow yourself to be forced into a quick
decision.
Do not allow friendship to influence an investment
decision.
If high-pressure marketing is involved, grab your
checkbook and run!!!
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Practical Element of
Personal Finance #12
Teach your children and
others how to earn
money and spend it
wisely.
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Teach Your Children Truths
About Money

Teach children money is earned by
providing services others’
value…Money does not grow on trees!

Money both helps us get what we
want, AND helps others get what they
want.

Success in general is realized by
setting goals and working hard to
achieve them…Achieve financial
success and security. Start now!
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