Financial Literacy

How to Maximize your Economic Happiness

Aaron Stevens
2 May 2011

Indicators of Physical
Health
Age
Blood pressure
Cholesterol
Body Mass Index (weight/height)
Diet/Nutrition
Physical Activity
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Indicators of
Financial Health
Assets
Liabilities/Debt
Income
Expenses
Risk Exposure
Sustainable Standard of Living
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Financial Literacy
Assets: what you own
Assets have value because they generate income (or can be sold).

Liabilities: what you owe

Liabilities are a claim against your future income. Debt payments
reduce the amount of income available for everything else.

Net Worth = Assets - Liabilities

Financial Literacy
How do you increase your Net Worth?
accumulate more assets by saving
pay off debts (also saving)
assets can increase in value

Financial Literacy
Income: what you earn
Expenses/Consumption: what you spend
Savings = Income - Consumption
Recall:
accumulate more assets by saving
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Credit Scores
students always ask
A credit score is a report card on your
level of debt and payment history.
It only matters if youre going to
spend your lifetime in debt.
I dont care! You shouldnt either!

How Much To Save?

A big problem in personal finance is
how much of your income to save.

Show: monthly spending plan

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The 3 Kinds of Savings

Everyone needs:
Retirement fund
An emergency fund
Savings for Major Purchases

A Simple Example
Joe Blow, age 22, not married, no kids.
No financial assets
Joe earns $42,000 per year
Joe will work until age 66, then drop
dead.
(No taxes, no transfers.)
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Earnings: $42,000
Consumption: $42,000
Savings: $0

(live to age 66)

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Economic Net Worth

Conventional Net Worth = A - L
What about human capital (HC)?
Human Capital is your asset which
throws off labor income each
year.
Economic Net Worth = CNW + HC
We can value Human Capital using
the time value of money.
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Earnings: $42,000
Consumption: $42,000
Savings: $0

(live to age 66)

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Saving For Retirement

Joe Blow, age 22, not married, no kids.
No financial assets
Joe earns $42,000 per year
Joe will work until age 66, and then
live until age 85. How will he eat?
(No taxes, no transfers.)
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Earnings: $42,000
Consumption: $36,380
Savings: $5,620

(live to age 85)

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Earnings: $42,000
Consumption: $36,380
Savings: $5,620

(live to age 85)

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Example, continued
Joe Blow, age 22, not married, no kids.
No financial assets
Joe earns $42,000 per year
Joe will work until age 66, and then
live until age 100.
(No taxes, no transfers.)
What are some of Joes possible
consumption paths?

Earnings: $42,000
Consumption: $34,204
Savings: $7,796

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(live to age 100)

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How to Save?
Its so hard to have money left over
at the end of the month. Usually I
have month left over at the end of the
money!
Saving money is incredibly hard!
It requires delayed gratification!
(once upon a time frugality was a
virtue)

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Pay Yourself First

The surest path to successful saving.
Have a portion of your paycheck set
aside for savings BEFORE it goes to
your bank account.
Spend the remainder after saving
first.

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Incentives for Saving

Uncle Barack wants you to be rich!
IRA, 401k/403b (Retirement Accounts)
save pre-tax dollars now, tax
deferred until you retire, pay taxes
upon withdrawal
Roth IRA/401k/403k
Save after-tax dollars now, no tax
when you withdraw at retirement

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Your Emergency Fund

YOU NEED TO SELF-INSURE AGAINST UNEMPLOYMENT!

Set up an emergency or reserve fund of

6-12 months of non-discretionary expenses.
You cannot afford to lose this money!

Your emergency fund must be risk-free: put it in

a Certificate of Deposit, or better yet iBonds.
DO NOT use this money to buy a car, vacation,
house, engagement ring, etc!

Start building your emergency

fund on day 1 of your first job!

Incentives For Saving

UNCLE BARACK WANTS YOU TO BE RICH!

Series I Savings Bonds

Risk-free, inflation-protected
Invest after-tax money
No state or local taxes ever
May defer taxes for up to 30 years
No federal tax if used for education

How to Buy I-Bonds

Set up an account at http://www.treasurydirect.gov/

ESPlanner
The only tool which uses the Life-Cycle Model

Try it free: www.esplanner.com/basic

Avoid borrowing for

Consumption
Borrowing involves reducing future
standard of living to pay for past
consumption.
When you borrow, you pay interest;
when you save, you earn interest.
Everything costs more when borrowing.
Save up in advance for major
purchases (cars, vacations, down
payment on house).

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Dont Trust Anyone!

Be ware of Broker/Dealers, Financial
Planners, Insurance Salespeople, etc.
Most are looking to sell you products, but
do not have your best interest at heart.
Salesmen are coin operated
Trust no-one; you alone are responsible for
your financial security.
Read everything and ask questions!
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EC 171: Personal
Lifecycle Economics
EC171 is an introduction to applied economics,
which applies the life cycle model to personal
economic decisions including: spending, saving,
borrowing, insuring; matriculation; choosing careers,
jobs, and locations; marrying, having children,
divorcing; retiring, retirement accounts, taking Social
Security; buying insurance; and investing in stocks
and bonds.

Offered Summer and Fall 2011

http://people.bu.edu/azs/teaching/ec171

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Want to Learn More?

www.esplanner.com/basic: software which uses the lifecycle model to
do trustworthy financial planning
Spend til the end by Laurence Kotlikoff and Scott Burns
The Only Investment Guide Youll Ever Need by Andrew Tobias
The Millionaire next Door by Thomas Stanley and William Danko

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