FNCE20003 Introductory Personal Finance Lecture 1 PDF

FNCE20003 Introductory Personal Finance Lecture 1 Introduction to Personal Finance Lecturer – Tony Cusack July 2024  Lecture 1 topics Administration and assessment Financial wellbeing Financial decision-making Introduction to course topics July 2024...

FNCE20003 Introductory Personal Finance Lecture 1 Introduction to Personal Finance Lecturer – Tony Cusack July 2024  Lecture 1 topics Administration and assessment Financial wellbeing Financial decision-making Introduction to course topics July 2024 FNCE20003 Lecture 1 2  Subject administration subject coordinator: Tony Cusack – room 11.057, Level 11, “The Spot” Building – email: [email protected] – consultation times: see Staff Information Module tutors and tutorials no prescribed text-book, weekly readings will be posted administrative issues → Stop 1: https://students.unimelb.edu.au/stop1 Discussions forum Assessment (MST is scheduled for 10am, Monday 9th September; Week 8) July 2024 FNCE20003 Lecture 1 3  Subject objectives the objectives of this subject include: – gaining an understanding of the concept of financial wellbeing, and examining personal financial decision making – review of alternative investment options and sources of finance (including analysis of risk and effective return) – paying particular attention to retirement planning including the impact of taxes and government incentives – understanding estate planning and asset protection, and – examining the role of financial advisers in constructing an appropriate personal financial plan July 2024 FNCE20003 Lecture 1 4  Your personal objectives you will be earning income and need to have a basis for making an effective allocation of disposable income between consumption and savings you will most likely be contributing to superannuation (or similar) all your working life, using your accumulated lump sum to provide for your retirement it is therefore obviously beneficial for you to know as much as you can about savings, investment and superannuation from the outset of your working life this subject provides a valuable opportunity to learn about consumption, investments and retirement funding and their place in your life note: your savings under your country’s national retirement scheme are likely to be your largest financial asset for much of your working life July 2024 FNCE20003 Lecture 1 5  Lecture 1 topics Administration and assessment Financial wellbeing July 2024 FNCE20003 Lecture 1 6  Consumer / household finance in the relevant academic literature, personal finance is typically referred to as consumer and/or household finance – this studies how individuals and households interact with financial instruments and markets topics studied in household finance include payment choices, saving, borrowing, asset allocation, insurance and financial advice – this is also the set of topics we will be covering in this subject a classic article is John Campbell “Household Finance” Journal of Finance, 2006 in this subject, we will not only be looking at the consumer/household side but also at the producer side, that is, the economics of providing certain financial services and products (as well as regulation) July 2024 FNCE20003 Lecture 1 7  Two broad focuses 1. Personal financial planning and management – financial wellbeing – types of personal financial decisions – investments and wealth creation – asset protection and estate planning – planning for retirement 2. Professional financial planning and advisory industry – financial advisors / planners – industry issues and regulation July 2024 FNCE20003 Lecture 1 8  Why does personal finance matter? the answer is obvious to most – it is directly linked to one’s quality of life the Comerton-Forde et al paper reports that about two thirds of Australians report that they worry about money on a monthly, weekly or daily basis – this is a worldwide phenomenon, of course only about one in five people rate their financial wellbeing as either ‘very high’ or ‘high’, and many suffer from “financial anxiety” many people also report regrets related to financial behaviours: not saving enough, not investing enough, not budgeting/planning enough another common regret is related to financial education: not learning more about finances/money July 2024 FNCE20003 Lecture 1 9  Drivers of financial anxiety main ones: the financing of retirement and providing for the family’s future KEY DRIVERS OF FINANCIAL ANXIETY 0 10 20 30 40 50 60 70 Financing retirement 57.3 Providing for family's future 50 Medical bills/healthcare 49.3 Non-essentials (holidays, eating out) 48 Home improvements & maintenance 47.5 Raising $2,000 in an emergency 47.1 Major household items 46.9 Mortgage, rent, housing costs 46 Source: NAB Australian Wellbeing Survey Q1 2020; 0: not at all concerned, 100: extremely concerned July 2024 FNCE20003 Lecture 1 10  Financial weaknesses Many Australian households are exposed to severe financial stress Australia has one of the highest levels of household indebtedness among OECD countries Australia has one of the highest old-age poverty rates among OECD countries most working Australians are considered to have inadequate retirement savings about 95% of Australian families are currently underinsured many have inadequate savings to deal with financial shocks – recall that about half say they would struggle to raise $2,000 in an emergency July 2024 FNCE20003 Lecture 1 11  Financial weaknesses References: Breitbach et al., FinFuture – The Future of Personal Finance in Australia, white paper, The University of Melbourne, 2019 July 2024 FNCE20003 Lecture 1 12  Defining financial wellbeing the paper defines financial wellbeing as the extent to which people both perceive and have each of 1. financial outcomes in which they meet their financial obligations, 2. financial freedom to make choices that allow them to enjoy life, 3. control of their finances, and 4. financial security now, in the future, and under possible adverse circumstances this definition has several dimensions, including situational/temporal, functional, and subjective/objective dimensions July 2024 FNCE20003 Lecture 1 13  Defining financial wellbeing the definition is based on prior studies and further informed by empirical analyses, which revealed that wellbeing has two primary components – the first component involves financial outcomes that people experience and interpret through a personal, subjective lens and that they can report – the second component involves financial outcomes that can be objectively observed in people’s financial records, accounts, and transactions i.e. peoples’ overall financial wellbeing consists of both outcomes as they perceive and experience them and outcomes as they can be objectively and independently observed this leads to the development of two measurement scales: (1) reported, and (2) observed financial wellbeing July 2024 FNCE20003 Lecture 1 14  Class Activity Questions: 1. What is the difference between the reported and observed financial wellbeing scales? 2. What are some advantages and disadvantages of both reported and observed scales? 3. The figure on the bottom of page 25 displays the relation between the level of a person’s understanding of financial products and their financial wellbeing. What is the likely mechanism(s) through which the two are related? Instructions: – Pair up with a student sitting next to you – Briefly introduce yourself to each other – Discuss each question and agree answer – 10 minutes July 2024 FNCE20003 Lecture 1 15  Financial wellbeing conceptual model Reference: Comerton-Forde et al., Using survey and banking data to measure financial wellbeing July 2024 FNCE20003 Lecture 1 16  Assumptions of the conceptual model people’s remaining lifetimes are divided into discrete periods in each of these periods, people care primarily about the amounts of goods and services they can consume the consumption of these goods and services generates what we observe as ‘financial behaviour’ people use their household economic and material resources to pay for their expenditures people’s economic and material resources are affected by their own behaviour as well as economic conditions around them people derive satisfaction from both their current expenditure and their beliefs about their future expenditure potential the correspondence between people’s derived satisfaction and their expenditures is characterised by their preferences and attitudes people make expenditure decisions in the best way possible given their personal capabilities and based on their access to financial products and services July 2024 FNCE20003 Lecture 1 17  Measuring reported financial wellbeing 1. In the last 12 months, how difficult was it for you to meet your necessary cost of living expenses like housing, electricity, water, health care, food, clothing or transport? How well do the following statements describe you or your situation? 2. I can enjoy life because of the way I’m managing my money 3. I could handle a major unexpected expense 4. I am securing my financial future How often do the following statements apply to you? 5. My finances control my life 6. I have money left over at the end of the month 7. Giving a gift for a wedding, birthday or other occasion would put a strain on my finances for the month When it comes to how you think and feel about your finances, please indicate the extent to which you agree or disagree with the following statements 8. I feel on top of my day-to-day finances 9. I am comfortable with my current levels of spending relative to the funds I have coming in 10. I am on track to have enough money to provide for my financial needs in the future July 2024 FNCE20003 Lecture 1 18  Measuring observed financial wellbeing 1. Number of months in last year with payment dishonours 2. Any payday loans in last year? 3. Days in last year with liquid balances below one week’s average expenses 4. Days in last year during which customer had the ability to raise one month’s expenses from savings or available credit 5. Age-normed percentile of customer’s median savings balance over last year Both reported and observed scales are normalised to the interval 0-100. July 2024 FNCE20003 Lecture 1 19  Objective vs subjective financial wellbeing unambiguously good financial wellbeing unambiguously poor financial wellbeing the other two are “ambiguous” Reference: Comerton-Forde et al., Using survey and banking data to measure financial wellbeing July 2024 FNCE20003 Lecture 1 20  Financial wellbeing scales – Australia July 2024 FNCE20003 Lecture 1 21  Financial wellbeing and other aspects of wellbeing July 2024 FNCE20003 Lecture 1 22  Financial wellbeing and financial literacy July 2024 FNCE20003 Lecture 1 23  Conceptual model – financial behaviour July 2024 FNCE20003 Lecture 1 24  Lecture 1 topics Administration and assessment Financial wellbeing Financial decision-making July 2024 FNCE20003 Lecture 1 25  Financial decisions that people make Consumption versus savings – Buy a new smart phone, bike or car, eat smashed avocado, take a holiday – Put an amount (say, $100 per week) into a long-term saving account – Increase contributions to superannuation Financing – Pay by cash or credit cards or personal loan or other deferral methods (BNPL)? – Rent or own, with home loan? – How much should I borrow? – How do I pay off borrowings? – Can I make decisions that will mean expenses are tax deductible? July 2024 FNCE20003 Lecture 1 26  Financial decisions that people make Investment – Should I invest my savings in a term deposit? – Which stock should I add to my portfolio? – Is now the right time to invest in equities / property / art? – How do I know if a managed fund is suitable for me? Asset protection – Should I buy life insurance? Car insurance? How much? – How would family breakdown affect my finance and wealth? – What will happen to my wealth / family if I die? July 2024 FNCE20003 Lecture 1 27  Financial decisions that people make Retirement decisions – When will I retire? Can I afford to retire at 50? 60? 70? many will have the FIRE (financial independence, retire early) motive (check out the FIRE calculator) – What are appropriate retirement funding strategies? – Will I have enough money? (How much money do I need?) – Do I need to keep earning in retirement? How? – Will I qualify for age pension? How much? How does age pension and other social security interact with my assets and income? July 2024 FNCE20003 Lecture 1 28  Regrets about financial choices REGRETS ABOUT FINANCIAL CHOICES 0 0.05 0.1 0.15 0.2 0.25 0.3 0.35 0.4 0.45 Not saving enough 0.399 Not investing enough 0.261 Not budgeting/planning enough 0.258 Not learning enough about finance 0.201 Spending beyond my means 0.197 Not shopping around enough for better deals 0.159 Making poor investment choices 0.146 Not working enough 0.132 Getting a credit card 0.111 Borrowing too much 0.105 Increasing credit card limit 0.1 Other 0.031 Source: UOM FinFuture Consumer Research, 2019 July 2024 FNCE20003 Lecture 1 29  Barriers keep people from improving their finances BARRIERS TO IMPROVING FINANCES 0 0.05 0.1 0.15 0.2 0.25 0.3 I do not trust financial institutions or advisers 0.277 Thinking about my finances is overwhelming 0.229 I do not have the skills to improve my finances 0.161 I do not have the time to spend on managing my finances 0.158 I find finance difficult to understand 0.115 I have little interest in money/finance 0.108 The right information about finance is not 0.1 available to me Source: UOM FinFuture Consumer Research, 2019 July 2024 FNCE20003 Lecture 1 30  Financial decision-making and its challenges much academic attention has been devoted to decision making standard models in decision theory assume that decision-makers choose such that the chosen action is the ‘best’ action available to them these models typically also assume that decision-makers have preferences that rank the available options the best option is the one ranked the highest according to the decision- maker’s preferences (which differ from person to person) the assumption that observed behaviour reflects the most preferred action is often referred to as “rational choice” July 2024 FNCE20003 Lecture 1 31  Financial decision-making and its challenges however, rationality faces a major challenge: in most real-life situations, acting rationally requires enormous cognitive / computational resources to determine optimal actions – however, people’s cognitive resources are limited therefore, in most decision situations, ‘full rationality’ is not possible various alternative models or frameworks have been suggested that take cognitive resources limitations into account (e.g. bounded rationality, heuristics, ecological rationality) another challenge, of course, is that almost all financial decisions are about the future and hence involve uncertainty July 2024 FNCE20003 Lecture 1 32  The ‘complexity’ barrier one aspect that encompasses both the different barriers listed and the effect of uncertainty, is the existence of complexity in financial markets and products – complexity of products (e.g. managed investment funds, insurance policies) – complexity of contracts (e.g. ‘boilerplate’ aka standard-form contracts, product disclosure statements) – complexity of distribution (e.g. marketing, data/algo ‘biases’, ‘dark patterns’) – size of search space (e.g. private health insurance, superannuation investment options) the last one represents “choice overload”, which refers to the paradoxical finding that providing individuals with more options can be detrimental July 2024 FNCE20003 Lecture 1 33  Example: the ‘choice overload’ problem July 2024 FNCE20003 Lecture 1 34  Lecture 1 topics Administration and assessment Financial wellbeing Financial decision-making High level overview of course topics July 2024 FNCE20003 Lecture 1 35  Finance theory and personal finance where does personal financial decision-making fit within finance theory? at a basic level, the following concepts are relevant: – consumption and savings – risk and return – diversification we also find that the following are also relevant: – mutual fund (Tobin) separation perfect capital markets assumption (i.e. the impact of it not holding) – Efficient Markets Hypothesis – agency theory July 2024 FNCE20003 Lecture 1 36  Financial planning the main areas of financial planning, whether by individuals themselves, or in consultation with Financial Planners (FP), are: – wealth creation – asset protection – retirement planning – estate planning given the specialist knowledge required in these different areas, most individuals will need to consult with an FP for appropriate guidance this is the reason that there are minimum standards set for members of the FP industry July 2024 FNCE20003 Lecture 1 37  Wealth creation the principal wealth creation strategies include (not necessarily in order): 1. Superannuation 2. Purchasing equities, bonds, property and other investment assets 3. Gearing 4. Investment in the family home 5. Investment in your own business 6. Salary packaging 7. Other? we will address most of these throughout the course July 2024 FNCE20003 Lecture 1 38  Retirement planning in this course, we spend some time addressing the problem of ensuring there will be adequate income to fund living in the non-working (retirement) phase our focus will be on income for retirement and in particular, the generation of an adequate retirement income stream (RIS) it raises the question: how much is needed to fund retirement? clearly, the answer to this relies upon a number of relevant variables – age, gender, life expectancy, existing debt, life-style objectives, hobbies, dependents, home ownership, other assets, etc. – these will determine the size of the superannuation lump sum to accumulate July 2024 FNCE20003 Lecture 1 39  Retirement income streams (RIS) RIS are generated by earnings from two broad sources: 1. superannuation assets, e.g. accumulation to fund RIS by way of: i. draw a pension from a super fund ii. purchase a term certain annuity iii. purchase a life annuity iv. apply a theory-based lump sum allocation strategy v. use of a SMSF (can enable any of (i. to iv.) 2. non-superannuation assets – e.g. rental income from investment properties, interest and dividends from cash, bonds and equity investments, royalties, annuities, non-superannuation pensions July 2024 FNCE20003 Lecture 1 40  Estate planning estate planning involves orderly (and tax-effective) disposal of your assets – this may be during your life or after you die – what is meant by estate? the main issue being addressed is: how do you go about the allocation of your estate? there are several variables to consider, e.g. a bequest motive – where assets are allocated via wills we will see that a Self Managed Superannuation Fund (SMSF) can be an efficient vehicle for estate planning (but subject to some restrictions) July 2024 FNCE20003 Lecture 1 41  Estate planning under this topic, we consider: – requirements for a valid will – intestacy and its consequences – the issue of dependents superannuation dependents tax dependents – disposal of assets that are not will assets joint and common tenancies, superannuation and trust assets – business succession planning July 2024 FNCE20003 Lecture 1 42  Asset protection protection of assets includes items such as: 1. adequate insurance cover – life, health, business, property 2. secure custody of assets 3. mechanisms in place for asset protection in the event of family breakdown 4. business breakdown/succession contingencies in place (if applicable) 5. risk mitigation measures in place against investment exposures (especially in retirement phase) July 2024 FNCE20003 Lecture 1 43  Going forward … the theory that we will cover first suggests that the key issue in personal finance is addressing the trade-off between consumption and savings of course, both are maximised if income is maximised, so it is appropriate for individuals to focus on income / wealth maximisation strategies – note that we are addressing this in the context of Finance learning … one outcome of this necessary (and widespread) focus is that there is a large Financial Planning services industry, both in Australia and worldwide as already noted, we will also address the features and regulations of the Financial Planning services industry in a later lecture July 2024 FNCE20003 Lecture 1 44