Financial Planning: Achieving Financial Goals through Effective Money Management - Prof. R, Study notes of Financial Management

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Test 1 Study Guide - Financial planning is important: - Need a financial plan because it’s easier to spend than to save - Want a financial plan since it helps you achieve financial goals - Use financial planning, not to make money, but to achieve goals *Control your finances or they will control you* -SMART goals- Specific, Measurable, Achievable, Realistic, Trackable -Insurance, salespeople, financial advisors and stockbrokers are paid on commissions - Paying your financial planner Fee only planners- earn income only through the fees they charge (you will personally have total control of the products purchased to complete your plan) Fee and commission planners- charge fees and also collect commissions on products they recommend ( your fees may be less if you do choose to buy some of their products, if dealing with unethical person- could be directed toward higher commission products) Fee offset planners- charge a fee, but then reduce this fee by any commissions they earn Commission based planners- work on a commission basis, most available type of advisor - Most financial products pay a commission to someone - Refer to Figure in notes for Financial Life Cycle: Stage 1- the early years- a time of wealth accumulation (purchase a home, prepare for child rearing costs, save for a child’s education, establish an emergency fund, start retirement savings) - Develop a regular patter of saving- years before age 54 Stage 2- Approaching Retirement- The Golden Years (retirement goals are the center of attention, continuously review your financial decisions, insurance protection and estate planning)- years between 55- 64 Stage 3- The Retirement Years (less risky investment strategy, review insurance, consider extended nursing home protection, estate planning decisions are critical) - 15 Principles 1- The Risk- Return Trade- off- savings allows for more future purchases, borrowers pay for using your savings, investors demand a minimum return to delay consumption, investors demand higher return for added risk 2- The Time Value of Money- Money received today is worth more than money received in the future, compound interest 3- Diversification Reduces Risk- “Don’t put all your eggs in one basket”, place money in several investments, not just one, diversification reduces risk without affecting expected return, won’t experience great returns or great losses- receive an average return 4- All Risk is not equal- Some risk cannot be diversified away, if stocks move in opposite directions —combining them can eliminate variability. If stocks move in same direction—not all variability can be diversified away 5- The curse of competitive investment markets- in efficient markets- information is instantly reflected in prices, cannot earn higher than expected profits from public information, difficult to “beat the market”- bargains don’t stay bargains for very long 6- Taxes affect personal finance decisions- taxes influence the realized return of investments, maximize after tax return, compare investment alternatives on an after- tax basis, benefit from available tax-deferred options, use annual income tax planning to your benefit 7- Stuff happens or the importance of liquidity- have funds available for the unexpected 8- Nothing happens without a plan- saving must be planned, “can’t save without thinking about it” 9- The best protection is knowledge- take responsibility for your financial affairs 10- Protect yourself against major catastrophes- have the right insurance before a tragedy occurs, know your policy coverage 11- The Time dimension of investing- take more risk on long term investments 12- The Agency problem- beware of the sales pitch- those who act as your agent may actually act in their own interest, find an advisor who fits your needs and is ethical and effective 13- Pay yourself first- pay yourself first so what you spend becomes the residual, reinforce the importance of long term goals, ensuring goals get funded 14- Money isn’t everything- extend financial plans to achieve future goals, know what’s important in life, money doesn’t bring happiness 15- Just do it! - Investment allies (time) is stronger now than it ever will be - Budgeting Process 1- What is important to the individuals/ household? What values influence goals? 2- Set realistic, progressive goals based on values (short term, intermediate term, long term) 3- Determine present income- if a guess, guess low. Who? When? How much? 4- Estimate present monthly expenses- fixed, flexible, occasional or irregular, oil or misc. 5- Plan a workable spending plan and record sheet; including savings as an expense (include amount planned per expense category, amount actually spent, and any variance) 6- Implement the budge and establish a method of record keeping 7- Try, revise, adjust spending, etc Ratios: - Current Ratio- shows whether you have enough liquid assets to cover expenses currently due (Monetary assets/ current liabilities)—ratio greater than 2 recommended, track trend-if going down- make changes -Month’s living expenses covered ratio- tells how many months living expenses you can cover with your present level of monetary assets (monetary assets/ month’s living expenses) - The rule of thumb- 3 to 6 months of expenses - factors that affect the rule of thumb (available credit cards or home equity loans, potential for higher earnings on less liquid accounts, stability of income) - track the trend and if going down- make changes - Debt Ratio- tells whether you could payoff all your liabilities if you liquidate all your assets, represents percentage of assets financed with borrowing, track the trend- ratio should go down with age - Long- term debt coverage ratio- ratio tells how many times you could make your debt payments with your current income, ratio of 2.5 or greater recommended, consider the inverse – the percentage of take- home pay needed to repay debt - Savings ratio- tells what proportion of your after-tax income is being saved, U.S. rate typically 3%- 8%, varies with stage of the financial life cycle and goals Time value of money - Future Value = FV= PV (1+ i) ^n or FV= PV (FVIF I,n)