The Fifteen Principles of Personal Finance

1. Risk Return Tradeoff

People save money to purchase goods or services in the future – in economic terms, to
delay consumption. Invested savings earn interest and the growth therefore means that
more can be purchased as a result. Interest is earned because some individuals, businesses
and the government are willing to pay for the use of that money. In effect, savings are lent
and the interest earned is the fee for the use.  The rate of return is dependent on the risk of
the investment. Some investments are safer than others and, therefore, the corresponding
interest is less.  (For example, Apple Computer bonds pay more interest than do US Treasury
Bonds.)

Read: Risk Return

Tradeoff: http://www.investopedia.com/university/concepts/concepts1.asp.

2. The Time Value of Money

A very important concept of personal finance is that money has a time value associated with
it – or – because of the opportunity to earn interest on any money received, money
received today is worth more than money received in a year. The importance of the time
value of money is that it allows a person to understand how an investment grows over time
and how to compare dollar amounts in different time periods. The term compound interest
is important in the calculation of the value of money over a period of time.

Read: Time Value of money

http://www.econedlink.org/lessons/index.php?lid=37&type=educator.

3. Diversification Reduces Risk

Diversification means spreading money across several investments rather than putting all of
one’s money into one investment. It allows for an average return if one investment booms
while another goes bust. While all risk in not eliminated, at least it is minimized.
4. All Risk is not Equal

While Principle 3 identifies that risk can be reduced by diversification, the fact that most
stocks tend to move together (climbing during market upswings and declining during the
downswings) means that not all variability can be diversified away. Not all risk is equal, and
the investor should be very concerned with risk that cannot be diversified away.

5. The Curse of Competitive Investment Markets

The goal of an investor is to create wealth. To do so requires an understanding of the worth

of different investments, such as stocks, bonds and real estate. It is very difficult to find
exceptionally profitable investments that outperform similar investments. The concept of
efficient markets is a powerful one due to the fact that in an efficient market a large number
of profit-driven investors act independently of one another, each looking for high returns.
With publicly available information, they make decisions to buy underpriced investments
(driving the price upward) and to sell overpriced investments (driving the price downward)
until equilibrium is reached.

6. Taxes Affect Personal Finance Decisions

The personal financial plan should serve to maximize the after-tax income available from
investments. Tax liabilities are not the same on all investments, so effective personal
financial planning requires an understanding of tax laws and their affect on investment
decisions.

7. Stuff Happens—or the Importance of Liquidity

While a majority of the focus of personal financial planning is long-term, there are occasions
where immediate, unexpected needs must be met: job loss or injury, for example. At this
time, it is important to have access to funds available so that long term investments are not
touched. The liquidation of long-term investments (real estate, stocks) might incur
unwanted tax liabilities or loss of return if the market is at a low point. Without liquid assets,
a person may be forced to borrow to cover unexpected expenses. A comprehensive
personal financial plan must include adequate liquid assets to meet unanticipated expenses.
8. Nothing Happens Without a Plan

Most people can spend money without thinking about it, but they cannot save money
without thinking about it.  Saving is not a natural event.  It must be planned.  A financial plan
should not be postponed.  The longer it is put off, the more difficult it becomes to
accomplish goals.   And often, when goals appear insurmountable, people do not even
attempt to reach them.

9. The Best Protection is Knowledge

While a professional financial planner can facilitate a personal financial plan,  individuals are
ultimately responsible for their own plan.  Knowledge and understanding of personal
finance is important for the following reasons:

 Defense against unethical, incompetent or unscrupulous characters

who may attempt to influence and take advantage of a situation (in
their best interest).

 Appreciation and understanding of the process will enhance

commitment to the process, which is sometimes challenging.

 Provides the ability to take advantage of opportunities (or avoid

problems) that arise as a result of changes in the economy and
interest rates.

 Abstract thinking often required for financial decision making is

easier when there is a basis of understanding.

10. Protection Against Major Catastrophes

Insurance is the tool to prevent a major financial disaster that may occur as a result of a
tragedy or other unforeseen major event.   Homes should be insured for catastrophes,
events that the owner cannot afford—hurricanes, tornadoes, earthquakes, floods, and fire,
for example.  It is important to know the right kind of insurance to purchase and the right
amount.   Most people purchase insurance based on recommendations made by the
insurance salesperson.  However, it is the responsibility of the purchaser to understand the
policy s/he purchases.  The time to determine if the amount or type of coverage is
appropriate is at the time of purchase, not after the tragedy has occurred.

11. The Time Dimension of Investing

Investments held over a long period of time generally support riskier decisions.  Riskier
investments generally provide a larger return.  In the investment arena,  over a long-time
horizon, exceptionally good times and exceptionally bad times will likely cancel each other
out.   Therefore, if an investment in the stock market is drawn out at retirement, it is more
likely that the return would be greater than if the funds had been invested in less risky
bonds.   If investments are made for the shorter term (to fund college, for instance), a
person would not want to run the risk of needing to draw out the funds if the market is
down.

12. The Agency Problem – Beware of the Sales Pitch

The Agency Problem occurs when sales agents (insurance salespeople, personal financial
advisors and stockbrokers) act in their own interest rather than the client’s best interest
because they may be motivated by high commissions for one sale over another.  A person
should not avoid insurance salespeople or financial planners, but beware of their motives
and refer to Principle 9 – The Best Protection is Knowledge.

13. Pay Yourself First

While it is easier to spend than to save, any saving activity is generally residual after
spending.  A habit of saving first acknowledges the importance of long-term goals and
ensures that those goals actually get funded.  Saving becomes automatic.

14. Money Isn’t Everything

Money doesn’t always mean happiness, but facing college expenses or retirement without
adequate funding brings on stress.   Personal financial planning allows a person to be
realistic about finances.  The total focus should not be on dollar signs alone. But on a
healthy perspective on what is important in life.

15. Just Do It!

Getting started may actually be the most difficult step in the personal financial planning
process.  There is no reason to postpone the commitment of planning and investment.  In
fact, it is critical that it is started early (see Principle 2—Time Value of Money).    So, just do
it.

Each of these fifteen principles, either independently or at times in combination, affects the
personal financial planning process.   An understanding and appreciation of these principles
is inherent in a successful personal financial plan.