Twelve Key Elements of
Practical Personal Finance
Common Sense Economics
James Gwartney, Richard L. Stroup,
Dwight R. Lee,...
Twelve Key Elements of
Practical Personal Finance
1) Discover your comparative advantage.
2) Be entrepreneurial. In a mark...
Twelve Key Elements of
Practical Personal Finance
5) Two ways to get more out of your money:
Avoid credit-card debt and co...
Twelve Key Elements of
Practical Personal Finance
9) Indexed equity funds can help you beat
the experts without taking exc...
Where do we begin??
• To begin this session, I would like each of
you to complete the “Personal Finance IQ
Quiz!”
– You wi...
Why Is There Financial
Insecurity in America?
• Do You Think It Is Because
Incomes Are Low?
– Not Really, see the next sli...
U.S. Income Is Rising and
Has Never Been Higher
Real Disposable Income Per Capita
35000

30000

Billions of 2000 Chained D...
Consumption Per Person Is Also
Growing
Real Disposible and Consumption Per Capita
30000

Billions of 2000 Chained Dollars
...
Financial Insecurity:
• Let’s take a look at how
households divide their
income between consumption
and savings.
• Remembe...
U.S. Saving Rates Are Falling
While Consumption Rates Are
Rising …
As a Percentage of Real Disposable Income
100%
90%
80%
...
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...
Revolving Debt as a % of Total Consumer Credit
50.00%
45.00%
40.00%
35.00%

Percentage

30.00%
25.00%
20.00%
15.00%
10.00%...
Real Unpaid Credit Card Balance Per U.S. Household
(2007 Dollars)
$10,000
$8,000
$6,000
$4,000
$2,000
$0
1970

1975

Commo...
Why do we need money,
when we have credit cards?
• A little videos on credit card
debt

CommonSenseEconomics.com

14
How much debt do we have
in America?

CommonSenseEconomics.com

15
A Student’s Story:

CommonSenseEconomics.com

16
And Interest on Household Debt as a Percentage of
Income

CommonSenseEconomics.com

17
Summarizing Trends in
Household Finance
• While real income per person is rising,
– The savings rate is falling, and
– Deb...
Planning to Achieve
Financial Security
• Set financial goals for the
short and long run.
– Put plans in place to
achieve t...
Why Do We Need or Want
Financial Security?
Financial security will help us
live less stressful lives and
pursue other goal...
“If you don't know where you are going,
you might wind up someplace else.”

~ Yogi Berra
CommonSenseEconomics.com

21
Practical Element of
Personal Finance #1
Discover your comparative advantage.

CommonSenseEconomics.com

22
Comparative Advantage
• Discover what you can produce at a lower cost than
others. Think opportunity costs!
• Find out wha...
Farmer John vs. Nurse Kelly: Can
They Gain From Specialization and
Trade?

CommonSenseEconomics.com

24
What’s Your Comparative Advantage?
• Think about what you are good
at doing and enjoy. Is this
something others’ value
hig...
Practical Element of
Personal Finance #2
Be entrepreneurial.

In a market economy, people maximize
their income by providi...
The Entrepreneur Next Door
• Entrepreneurs actively
pursue discovering
better ways of doing
things.
• They act quickly and...
Entrepreneurial Fuel

CommonSenseEconomics.com

28
Entrepreneurs’ Success:
1. Entrepreneurial talent: the
ability to discover
a.
b.
c.

new products that are highly
valued r...
Entrepreneurs’ Success:
2. Tolerance for risk: Entrepreneurial
activity and self-employment are
riskier than being employe...
Entrepreneurs’ Success
(cont.)
3. High Savings Rates:
Entrepreneurs have high
savings rates. Often they
invest in their bu...
Entrepreneurs’ Success
(cont.)
4. Work Hard and Smart:
Entrepreneurs, business
owners and independent
contractors tend to ...
#2 Be Entrepreneurial
Ken Olson, chairman/founder of Digital Equipment
Corp., 1977: "There is no reason anyone would
want ...
Practical Element of Personal
Finance #3
Spend Less Than You Earn

CommonSenseEconomics.com

34
Why Should You Save?
• Increase your wealth.
• Live a less stressful,
more financially free
life.
• Achieve high
consumpti...
How Do You Start?
• Just do it.
• Make savings a part of your
monthly plans, e.g. channel a
designated amount into an
elec...
Just Do It!!!
• Exert the willpower to save now.
• It is unlikely that you will do so later.
• If you wait to save until y...
Coffee Anyone?
•

Many people buy one premium cup of
coffee each day. Assume each cup
costs $4. If they could earn a 7%
re...
Strategic Savings

• Tax deferred savings.
– Automatically deduct savings from your gross
income, thereby reducing your ta...
Practical Element of
Personal Finance #4
Don’t finance anything
for
longer than its useful
life.
CommonSenseEconomics.com
...
Financing Consumption
•

•

Purchase on credit only
when you are buying
revenue generating
assets in order to earn
positiv...
Good Debt. When can you finance?
When goods and services financed
now promise to yield a return
greater than cost (princip...
What Should Not Be
Financed?
• Nondurables – Goods that are
consumed or items that lose their
value quickly.
– Food
– Clot...
Practical Element of
Personal Finance #5
Get More Out of
Your Money

CommonSenseEconomics.com

44
How???
• Two ways:
–
–

Avoid credit card debt
Consider purchasing used
items

CommonSenseEconomics.com

45
Paint a Bright Future!!!
•
•
•

Save today and spend in the future!
Use credit cards wisely and pay them
off immediately.
...
Credit Card Convenience
• Paying with a credit card is NOT
spending your own money, but
borrowing someone else’s IF you do...
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...
Buy Used
When Strategic

• Is buying new worth it?
• Depreciation costs make new cars
expensive. They depreciate
substanti...
Do Credit Card Companies Prey on the
Financially Illiterate and Undisciplined?
• Advertisement of a credit card
company: “...
Do Credit Card Companies
Think You Are Suckers?
• 0% Introductory APR on all purchases and
balance transfers for up to 6 m...
Practical Element of
Personal Finance #6
Pay into a “realworld” savings
account every
month.
CommonSenseEconomics.com

52
Rainy Days and the Real World
•

Life is full of “surprises”,
and they’re usually
expensive!
• Cars break down.
• Heaters ...
Plan For Your Rainy Days!
• The only “surprise” is
the timing. So put a
plan in place!
• Purchase “peace of
mind” by build...
Practical Element of
Personal Finance #7

Put the power of
compound interest
to work for you.
CommonSenseEconomics.com

55
It’s a Miracle!!!
• Save and invest
regularly. There is a
huge payoff!
• Compound interest
allows you to earn
more and mor...
The Rule of 70
• Determine how long it takes to double your
investment.
– Place funds in an investment and let it grow ove...
Take A Closer Look
• Save $2000 at the age of 16 and place it in an
investment that promises a 10 percent return.

– How l...
Practical Element of
Personal Finance #8
Diversify - don’t put all of your eggs in one
basket.

CommonSenseEconomics.com

...
Accumulate Wealth and
Gain Financial Security
• Investments involve risk, especially in the
short-run.
• Manage this risk ...
The Law of Large Numbers
The law of large numbers states that while some of the
investments in a diversified portfolio wil...
Avoid Double Jeopardy
• Does your employer offer a company stock-based
retirement program or agree to match any income
use...
Practical Element of
Personal Finance #9
Indexed equity funds can
help you beat the experts
without taking excessive
risk....
The Random Walk Theory
• No one person, group of experts, or
company can predict future changes
in the stock market.
• The...
Mutual Funds
• Mutual Funds
– A mutual fund pools the savings
of many individuals and
channels them into alternative
inves...
Two Types of Equity Funds
• Managed equity funds are administered by
professionals, seeking to pick and choose stocks.
A l...
Indexed Equity Funds vs.
Managed Funds
• Because their holdings simply mirror a broad
index, indexed equity funds do not r...
Practical Element of
Practical Personal
Finance #10
Invest in stocks for long-run objectives;
as the need for money approa...
Hold On
• You have built a diversified
portfolio and set long-term
financial goals.
• You channel savings to cover
unexpec...
Stocks vs. Bonds
• Historically, the real return from
stocks (about 7%) has been higher
than for bonds (about 3%).
• The s...
Bonds: Two Main Types of Risks
• Inflation risk: Unexpected inflation erodes the
purchasing power of the face value of the...
Bond Investment Strategies
– Buy bonds that mature when
funds will be needed. If you
need funds in five years, buy a
five ...
Practical Element of Personal
Finance #11
Beware of investment
schemes promising high
returns with little or no risk.

Com...
There’s no such thing as a free
lunch!!!
• Beware of deals that sound too
good to be true!
• The principal-agent problem
m...
1.
2.
3.
4.
5.
6.

Tips for Avoiding
Investment Fraud

If it looks too good to be true, it probably is.
Deal only with par...
Practical Element of
Personal Finance #12
Teach your children and
others how to earn money
and spend it wisely.

CommonSen...
Teach Your Children Truths About
Money
• Teach children money is earned by
providing services others’ value…
Money does no...
Review
•
•
•

Understand the causes of the
financial insecurity in America
Know how to effectively budget your
money and t...
Review
Know the 12 Key Elements of Personal Finance
(continued):
4.
Don’t finance anything for longer than its useful
life...
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  1. 1. Twelve Key Elements of Practical Personal Finance Common Sense Economics James Gwartney, Richard L. Stroup, Dwight R. Lee, and Tawni H. Ferrarini CommonSenseEconomics.com CommonSenseEconomics.com 1
  2. 2. Twelve Key Elements of Practical Personal Finance 1) Discover your comparative advantage. 2) Be entrepreneurial. In a market economy, people get ahead by helping others and discovering better ways of doing things 3) Use budgeting to help you save regularly and spend your money more effectively. 4) Don’t finance anything for longer than its useful life. CommonSenseEconomics.com 2
  3. 3. Twelve Key Elements of Practical Personal Finance 5) Two ways to get more out of your money: Avoid credit-card debt and consider purchasing used items. 6) Begin paying into a “real-world” savings account every month. 7) Put the power of compound interest to work for you. 8) Diversify-don’t put all of your eggs in one basket. CommonSenseEconomics.com 3
  4. 4. Twelve Key Elements of Practical Personal Finance 9) Indexed equity funds can help you beat the experts without taking excessive risk. 10) Invest in stocks for long-run objectives, but as the need or money approaches, increase the proportion of bonds. 11) Beware of investment schemes promising high returns with little or not risk. 12) Teach your children how to earn money and spend it wisely. CommonSenseEconomics.com 4
  5. 5. Where do we begin?? • To begin this session, I would like each of you to complete the “Personal Finance IQ Quiz!” – You will find the document posted under course resources for this week. – I will post the answers to the quiz at the end of the week!! CommonSenseEconomics.com 5
  6. 6. Why Is There Financial Insecurity in America? • Do You Think It Is Because Incomes Are Low? – Not Really, see the next slide!!! CommonSenseEconomics.com 6
  7. 7. U.S. Income Is Rising and Has Never Been Higher Real Disposable Income Per Capita 35000 30000 Billions of 2000 Chained Dollars 25000 20000 15000 10000 5000 0 1970 1975 1980 CommonSenseEconomics.com 1985 1990 1995 2000 2005 7
  8. 8. 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 CommonSenseEconomics.com 1980 1985 1990 1995 2000 2005 Year Real Personal Disposible Income Per Capita (2000 Dollars) Real Personal Consumption Per Capita (2000 dollars) 8
  9. 9. 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. CommonSenseEconomics.com 9
  10. 10. 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 CommonSenseEconomics.com 1995 1980 1985 1990 Savings Rate 2000 Consumption Rates 200510
  11. 11. 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 CommonSenseEconomics.com 1975 1980 1985 1990 11 1995 2000 2005
  12. 12. Revolving Debt as a % of Total Consumer Credit 50.00% 45.00% 40.00% 35.00% Percentage 30.00% 25.00% 20.00% 15.00% 10.00% 5.00% 0.00% 1970 1975 1980 CommonSenseEconomics.com 1985 1990 Year 1995 2000 12 2005
  13. 13. Real Unpaid Credit Card Balance Per U.S. Household (2007 Dollars) $10,000 $8,000 $6,000 $4,000 $2,000 $0 1970 1975 CommonSenseEconomics.com 1980 1985 1990 1995 2000 2005 13
  14. 14. Why do we need money, when we have credit cards? • A little videos on credit card debt CommonSenseEconomics.com 14
  15. 15. How much debt do we have in America? CommonSenseEconomics.com 15
  16. 16. A Student’s Story: CommonSenseEconomics.com 16
  17. 17. And Interest on Household Debt as a Percentage of Income CommonSenseEconomics.com 17
  18. 18. 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. CommonSenseEconomics.com 18
  19. 19. 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. CommonSenseEconomics.com 19
  20. 20. 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 CommonSenseEconomics.com 20
  21. 21. “If you don't know where you are going, you might wind up someplace else.” ~ Yogi Berra CommonSenseEconomics.com 21
  22. 22. Practical Element of Personal Finance #1 Discover your comparative advantage. CommonSenseEconomics.com 22
  23. 23. 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. CommonSenseEconomics.com 23
  24. 24. Farmer John vs. Nurse Kelly: Can They Gain From Specialization and Trade? CommonSenseEconomics.com 24
  25. 25. 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? CommonSenseEconomics.com 25
  26. 26. 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. CommonSenseEconomics.com 26
  27. 27. The Entrepreneur Next Door • Entrepreneurs actively pursue discovering better ways of doing things. • They act quickly and strategically on new opportunities. CommonSenseEconomics.com 27
  28. 28. Entrepreneurial Fuel CommonSenseEconomics.com 28
  29. 29. Entrepreneurs’ Success: 1. Entrepreneurial talent: the ability to discover a. b. c. new products that are highly valued relative to costs, cost-reducing production methods, and profitable opportunities that others overlook. CommonSenseEconomics.com 29
  30. 30. Entrepreneurs’ Success: 2. 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. CommonSenseEconomics.com 30
  31. 31. Entrepreneurs’ Success (cont.) 3. High Savings Rates: Entrepreneurs have high savings rates. Often they invest in their businesses, adding to their wealth. CommonSenseEconomics.com 31
  32. 32. Entrepreneurs’ Success (cont.) 4. Work Hard and Smart: Entrepreneurs, business owners and independent contractors tend to work longer hours and more strategically. CommonSenseEconomics.com 32
  33. 33. #2 Be Entrepreneurial Ken Olson, chairman/founder of Digital Equipment Corp., 1977: "There is no reason anyone would want a computer in their home." Fred Smith’s (FedEx) Yale University Senior Project Grade Remark: "The concept is interesting and well-formed, but in order to earn better than a 'C,' the idea must be feasible." 33
  34. 34. Practical Element of Personal Finance #3 Spend Less Than You Earn CommonSenseEconomics.com 34
  35. 35. Why Should You Save? • Increase your wealth. • Live a less stressful, more financially free life. • Achieve high consumption levels in the future. CommonSenseEconomics.com 35
  36. 36. 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. CommonSenseEconomics.com 36
  37. 37. 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. CommonSenseEconomics.com 37
  38. 38. 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. Nothing. The coffee is consumed! b. $1,460 c. $73,000 d. $ 443,918 CommonSenseEconomics.com 38
  39. 39. 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 39 more.
  40. 40. Practical Element of Personal Finance #4 Don’t finance anything for longer than its useful life. CommonSenseEconomics.com 40
  41. 41. 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! CommonSenseEconomics.com 41
  42. 42. 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 – Automobiles (in some cases) – Education Under certain circumstances, these assets generate income and wealth over time. They can help increase your net worth (assets less liabilities). CommonSenseEconomics.com 42
  43. 43. What Should Not Be Financed? • Nondurables – Goods that are consumed or items that lose their value quickly. – Food – Clothing – Entertainment – Vacations 43
  44. 44. Practical Element of Personal Finance #5 Get More Out of Your Money CommonSenseEconomics.com 44
  45. 45. How??? • Two ways: – – Avoid credit card debt Consider purchasing used items CommonSenseEconomics.com 45
  46. 46. 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.” CommonSenseEconomics.com 46
  47. 47. 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. CommonSenseEconomics.com 47
  48. 48. 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? CommonSenseEconomics.com 48 • $0, $130.40, about $260, over $1300? • $1300 in interest! And the items costing $2000 are gone!
  49. 49. 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. CommonSenseEconomics.com 49
  50. 50. 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? CommonSenseEconomics.com 50
  51. 51. Do Credit Card Companies Think You Are Suckers? • 0% Introductory APR on all purchases and balance transfers for up to 6 months • No annual fee • Earn 15 Karma Points just by getting approved for a Chase credit card • Earn more Karma Points at Facebook.com/plus • Share points with friends, give points to support causes Get the limited edition Facebook t-shirt with 10 Karma Points • Get music, movies, electronics and more with your Karma Points in the Chase +1 store • Why do you think you get so 51 many applications?
  52. 52. Practical Element of Personal Finance #6 Pay into a “realworld” savings account every month. CommonSenseEconomics.com 52
  53. 53. Rainy Days and 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. CommonSenseEconomics.com 53
  54. 54. 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! CommonSenseEconomics.com 54
  55. 55. Practical Element of Personal Finance #7 Put the power of compound interest to work for you. CommonSenseEconomics.com 55
  56. 56. 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! 56
  57. 57. 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) CommonSenseEconomics.com 57
  58. 58. 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) CommonSenseEconomics.com 58
  59. 59. Practical Element of Personal Finance #8 Diversify - don’t put all of your eggs in one basket. CommonSenseEconomics.com 59
  60. 60. 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! CommonSenseEconomics.com 60
  61. 61. 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. CommonSenseEconomics.com 61
  62. 62. 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 62 company fails, you lose both. Diversify!
  63. 63. Practical Element of Personal Finance #9 Indexed equity funds can help you beat the experts without taking excessive risk. CommonSenseEconomics.com 63
  64. 64. 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”. CommonSenseEconomics.com 64
  65. 65. 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. CommonSenseEconomics.com 65
  66. 66. 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. 66
  67. 67. 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 67 their managed counterparts.
  68. 68. 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. CommonSenseEconomics.com 68
  69. 69. 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”. 69
  70. 70. 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. CommonSenseEconomics.com 70
  71. 71. 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. CommonSenseEconomics.com 71
  72. 72. 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. CommonSenseEconomics.com 72
  73. 73. Practical Element of Personal Finance #11 Beware of investment schemes promising high returns with little or no risk. CommonSenseEconomics.com 73
  74. 74. 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 74 should be skeptical. CommonSenseEconomics.com
  75. 75. 1. 2. 3. 4. 5. 6. Tips for Avoiding Investment Fraud 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!!! 75
  76. 76. Practical Element of Personal Finance #12 Teach your children and others how to earn money and spend it wisely. CommonSenseEconomics.com 76
  77. 77. 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! 77
  78. 78. Review • • • Understand the causes of the financial insecurity in America Know how to effectively budget your money and the importance of saving now for your future. Know the 12 Key Elements of Personal Finance: 1. Discover your comparative advantage 2. Be entrepreneurial 3. Spend less than you earn (Save 78 Now!)
  79. 79. Review Know the 12 Key Elements of Personal Finance (continued): 4. Don’t finance anything for longer than its useful life. 5. Get more out of your money (avoid credit card debt and buy used) 6. Establish a real-world savings account 7. Harness the power of compound interest 8. Diversify 9. Indexed equity funds can help you beat the market 10. Invest in stocks for the long run and bonds for the short run 11. Beware of investment schemes promising high returns and little to no risk 12. Teach your children about money (earning and 79 saving)

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