Lecture 1: Managing Your Personal Finance PDF

GE1202 Managing Your Personal Finance Lecture 1 Introduction to Personal Finance Management Who Need to Know Personal Finance Planning? Every person has some money available Most people want to handle their finances so that they get full satisfaction from each available dollar Finan...

GE1202 Managing Your Personal Finance Lecture 1 Introduction to Personal Finance Management Who Need to Know Personal Finance Planning? Every person has some money available Most people want to handle their finances so that they get full satisfaction from each available dollar Financial Goals Buying a new car or getting a larger home Pursuing advanced career training Contributing to charity Traveling extensively Ensuring self-sufficiency during working and retirement years Holding a fantastic wedding party Financial Planning As we have limited money, it is impossible to have all the goals to be realized To achieve these goals, you need to identify and set priorities. The process of managing your money to achieve personal economic satisfaction Personal money management or Personal financial planning Financial decision must be planned to meet the unique situation facing each person. People in their 20s spend differently from those in their 50s Life situation/style – Adult Life Cycle Adult Life Cycle Financial Planning Financial Plan A formalized report that summarize your current situation, analyzes your financial needs, and recommends future financial activities. Advantages of effective personal financial planning Increased effectiveness in obtaining, using, and protecting your financial resources throughout your life Increased control of your financial affairs by avoiding excessive debt, bankruptcy, and dependence on others Improved personal relationships resulting from well-planned and effectively communicated financial decisions A sense of freedom from financial worries obtained by looking to the future, anticipating expenses, and achieving personal economic goals Goal-Setting Guidelines Financial goals should take a SMART approach. Specific – know exactly what your goals are and can create a plan to achieve those objectives Measurable – can be measured by a specific amount Action oriented - provide the basis for the personal financial activities you will undertake. Realistic – involve goals based on your income and life situation Time based – indicate a time frame for achieving the goal Which is SMARTer? A fresh graduate just starts his career as a secondary school teacher. Plan A: Buy a flat in Kowloon Tong by 30. Plan B: Put $5,000 into the saving account each month for 8 years as the down payment for a flat of $6M in Kowloon Bay. Types of Financial Goal There are 3 different financial goals Consumable-Product Goals Food, clothing, entertainment Durable-Product Goals “Big ticket” items like appliances and cars Intangible-Product Goals Health, education, relationships, service Types of Financial Goal There are 3 different time frames for achieving financial goals Short term goals Will be achieved within the next year Saving for a vacation, buying a new phone Intermediate goals Two to five years Further study, Wedding Long term goals More than five years Retirement, children’s education expenses Components of Personal Financial Planning There are Eight major personal financial planning areas Obtaining – the receipt of income and other financial resources Planning – actions to determine future financial directions Saving – set aside funds for expected and unexpected expenses Borrowing – appropriate use of short-and-long-term credit plans Spending – analysis of purchasing decisions for wise money use Managing Risk – insurance and other methods to reduce financial uncertainty Investing – accumulation of funds for long-term financial security Retirement and Estate Planning – efforts to provide for post-career years and transfer of assets Factors Influence Financial Decisions Personal factors Age Income Household size Personal beliefs General factors Global economy Inflation rate Interest rate Global Economy Economy influences financial planning Phases of the business cycle: expansion, peak, contraction, trough (takes 4-5 years on average) Economics: the study of how wealth is created and distributed; strongly influences financial planning Decisions made by Central Banks (e.g., interest rates, money supply) Inflation Inflation is a rise in the general price level The general price level is measured by the Consumer Price Index (CPI) CPI is the weighted average of the prices of a fixed basket of goods and services 𝐶𝑜𝑠𝑡 𝑜𝑓 𝑡ℎ𝑒 𝑏𝑎𝑠𝑘𝑒𝑡 𝑖𝑛 𝑡ℎ𝑒 𝑐𝑢𝑟𝑟𝑒𝑛𝑡 𝑦𝑒𝑎𝑟 𝐶𝑃𝐼 = × 100 𝐶𝑜𝑠𝑡 𝑜𝑓 𝑡ℎ𝑒 𝑏𝑎𝑠𝑘𝑒𝑡 𝑖𝑛 𝑡ℎ𝑒 𝑏𝑎𝑠𝑒 𝑦𝑒𝑎𝑟 Inflation rate is the % change in the CPI 𝐶𝑃𝐼𝑐𝑢𝑟𝑟𝑒𝑛𝑡 𝑦𝑒𝑎𝑟 − 𝐶𝑃𝐼𝑙𝑎𝑠𝑡 𝑦𝑒𝑎𝑟 𝐼𝑛𝑓𝑙𝑎𝑡𝑖𝑜𝑛% = × 100% 𝐶𝑃𝐼𝑙𝑎𝑠𝑡 𝑦𝑒𝑎𝑟 Inflation Product Price in 2015 Quantity in 2015 Price in 2016 Quantity in 2016 iphone $1000 10 $1100 12 iMac $2000 5 $2500 6 ipod $500 4 $550 3 $1000×10+$2000×5+$500×4 𝐶𝑃𝐼2015 = × 100 = $1000×10+$2000×5+$500×4 $1100×𝟏𝟎+$2500×𝟓+$550×𝟒 𝐶𝑃𝐼2016 = × 100 = $1000×10+$2000×5+$500×4 116.8 −100 𝐼𝑛𝑓𝑙𝑎𝑡𝑖𝑜𝑛 % = × 100% = 100 Inflation Inflation erodes the purchasing power of money The quantity of goods that can be bought with a sum of money reduces Examples: How many apples can be bought with $100 if each apple costs $10? How many apples can be bought with $100 if each apple costs $11? You can buy 1 apple (10%) less when the price goes up by $1 (10%) with the $100 𝑁𝑜𝑚𝑖𝑛𝑎𝑙 𝑣𝑎𝑙𝑢𝑒 𝑜𝑓 𝑚𝑜𝑛𝑒𝑦 𝑃𝑢𝑟𝑐ℎ𝑎𝑠𝑖𝑛𝑔 𝑝𝑜𝑤𝑒𝑟 𝑜𝑓 𝑚𝑜𝑛𝑒𝑦 = 𝐶𝑃𝐼 % △ Real value = % △ Nominal value – Inflation% Interest To maintain the purchasing power of money, you may invest them into interest-yielding assets. What is interest? Lender – compensation for giving up earlier availability of resources Borrower – cost of acquiring earlier availability of resources Investor – return on financial investment Interest on deposits Interest on bonds Dividend and capital gains from stocks Interest Interest raises the nominal value of money You get back $110 a year later if you deposit $100 into a bank which pays interest 10% p.a. Real value of money may increase, decrease or remain unchanged with interest during the time of inflation You save $100 into a deposit which gives interest 10% p.a. and the initial price level is 100 Inflation rate %△ %△ Nominal value Real value (π) Nominal value Real value 0% 10% 15% Time Value of Money Why do we need to pay interest? As people prefer early consumption to late, people place higher value on current consumption The dollar received today is worth more than a dollar that will be received one year from today Time Value of Money Compounding The process of finding the future value from a current sum based on a certain interest rate and period of time If you put $1000 into a bank deposit which offers an interest rate of 10% p.a., how much will you get after 10 years? Discounting The process of finding the current value from a future sum based on a certain interest rate and period of time How much do you need to put into your bank account which offers an interest rate of 10% p.a., how much will you get after 10 years? Compounding If you put $100 into your bank account for 3 years with an interest of 10%p.a., how much should you expect to get back? To find the future value of a Single amount 𝐹𝑉 = 𝑃𝑉 1 + 𝑖 𝑛 FV = Future Value; PV = Present Value; i = interest rate; n = time periods Compounding If you put $100 into your bank account in the beginning of each year for 3 years with an interest of 10%p.a., how much should you expect to get back? A stream of constant amount is called Annuity To find the future value of a Series of equal amounts 1+𝑖 𝑛−1 𝐹𝑉 = 𝐴𝑛𝑛𝑢𝑖𝑡𝑦 × × (1 + 𝑖) 𝑖 Compounding 3rd $100 What is the sum of these 2nd $100 amounts? 1st $100 0 1 2 3 Compounding If you put $100 into your bank account at the end of each year for 3 years with an interest of 10%p.a., how much should you expect to get back? 3rd $100 What is the 2nd $100 $110 sum of these 1st amounts? $100 $110 $121 0 1 2 3 1+𝑖 𝑛−1 𝐹𝑉 = 𝐴𝑛𝑛𝑢𝑖𝑡𝑦 × 𝑖 Discounting How much should you put into your bank account with an interest of 10%p.a. so as that you can get back $133.1 after 3 years? To find the present value of a Single amount 𝐹𝑉 𝑃𝑉 = 𝑛 1+𝑖 Discounting If you wish to withdraw $100 at the end of each year for 3 years from an account that earns interest 10% p.a., how much you should deposit not? To find the present value of a Series of equal amounts 1 1− 𝑛 1+𝑖 𝑃𝑉 = 𝐴𝑛𝑛𝑢𝑖𝑡𝑦 × 𝑖  Discounting What is the $100 1st sum of these $100 2nd amounts? $100 3rd 0 1 2 3 Opportunity Cost Opportunity cost is what you give up by making a choice Trade-off of a decision Example 1: You may spend $200 to have meal with your friend or to buy the textbook. What is your opportunity cost for you to buy the textbook? Example 2: You may spend $200 to buy the textbook or save it to earn an interest of 10% What is your opportunity cost for you to buy the textbook? Interest rate is the opportunity cost for current consumption. A Plan for Personal Financial Planning We all make hundreds of decision each day Some are complex and have long-term effects on our personal and financial situations Few people consider how to make better decisions Six-step financial planning process 1. Determine your 6. Review and 2. Develop your current financial revise the plan financial goals situation 5. Create and 4. Evaluate 3. Identify alternative implement alternatives courses of actions your plan Step 1: Determine Your Current Financial Situation Check out your current financial situation Income Savings Living expenses Debts Prepare your personal financial statement A list of current asset and debt balances and amounts spent for various items The foundation for financial planning activities Step 2: Develop Your Financial Goals Analyze your financial values and goals periodically Differentiate your needs from your wants Your financial goals can range from spending all of your current income to developing an extensive savings and investment program for your future financial security Step 3: Identity Alternative Courses of Action Possible courses of action usually fall into these categories Continue the same course of action Expand the current situation Change the current situation Take a new course of action Not all of these categories will apply to every decision Consider all of the possible alternatives will help you make more effective and satisfying decisions Step 3: Identity Alternative Courses of Action Example: You are saving $1000 into your bank account every month. What are the possible courses of action available to you? Continue to save the same amount. Save $500 more Invest it into the stock market Pay off your credit card debts Do nothing!!! Step 4: Evaluate Your Alternatives Evaluating the alternatives, you should always keep in mind the following two aspects: 1. Consequences of choices Every decision has an opportunity cost. The trade-off cannot always be measured in money, but the resources you give up have a value that is lost Example: You are considering to take a Master degree after finishing your undergraduate degree or take up a job offer by a famous company. What is your opportunity cost if you end up with taking the master degree? Income; working experience; skills Job satisfaction Step 4: Evaluate Your Alternatives 2. Evaluating risk Uncertainty is also a part of every decision Different decisions involve difference degree of risk In many financial decisions, identifying and evaluating risk are difficult. Common risk to consider Inflation risk Interest rate risk Income risk Personal risk Liquidity risk Step 4: Evaluate Your Alternatives The best way to consider risk is to gather information based on your and others’ experience and to use financial planning information sources. Common sources The Internet Media sources Financial institutions Financial specialists A larger amount and more advanced information is needed when more risks are associated with a decision. Some more things to consider Your life situations; personal values, current economic conditions, etc Step 5: Create and Implement Your Plan Develop an action plan to achieve your goals The plan has to be realistic and achievable Example Your friend is planning to have his own home after 3 years from graduate He is targeting on a flat of size 600 sq. feet, which selling at $5M He is expecting to get a job paying him $30,000 per month He will save $28,000 per month and get it accumulated to $1M in 3 years for the down payment What will you say to your friend? God Bless You!!! Step 6: Review and Revise Your Plan Financial planning is a dynamic process Regularly assess your financial decisions A complete review should be done at least once a year Changing personal, social, and economic factor may require more frequent assessments A regular review will help you make priority adjustments that will bring your financial goals and activities in line with your current life situation