In 1947, Herbert A. Simon, a Nobel laureate, suggested that a decision maker did not always make the best financial decision because of limited educational resources and personal inclinations. In 2009, Dan Ariely suggested the 2008 financial crisis showed that human beings do not always make rational financial decisions, and the market is not necessarily self-regulating and corrective of any imbalances in the economy.
Therefore, personal finance education is needed to help an individual or a family make rational financial decisions throughout their life. Before 1990, mainstream economists and business faculty paid little attention to personal finance. However, several American universities such as Brigham Young University, Iowa State University, and San Francisco State University have started to offer financial educational programmes in both undergraduate and graduate programmes in the last 30 years. These institutions have published several works in journals such as The Journal of Financial Counseling and Planning and the Journal of Personal Finance. Research into personal finance is based on several theories such as social exchange theory and andragogy (adult learning theory). Professional bodies such as American Association of Family and Consumer Sciences and American Council on Consumer Interests started to play an important role in the development of this field from the 1950s to 1970s. The establishment of the Association for Financial Counseling and Planning Education (AFCPE) in 1984 at Iowa State University and the Academy of Financial Services (AFS) in 1985 marked an important milestone in personal finance history. Attendances of the two societies mainly come from faculty and graduates from business and home economics colleges. AFCPE has since offered several certifications for professionals in this field such as Accredited Financial Counselor (AFC) and Certified Housing Counselors (CHC). Meanwhile, AFS cooperates with Certified Financial Planner (CFP Board).
As the concerns about consumers' financial capability have increased in recent years, a variety of education programmes has emerged, catering to a broad audience or to a specific group of people such as youth and women. The educational programmes are frequently known as "financial literacy". However, there was no standardised curriculum for personal finance education until after the 2008 financial crisis. The United States President's Advisory Council on Financial Capability was set up in 2008 in order to encourage financial literacy among the American people. It also stressed the importance of developing a standard in the field of financial education.
Personal financial planning process
The key component of personal finance is financial planning, which is a dynamic process that requires regular monitoring and re-evaluation. In general, it involves five steps:
Assessment: A person's financial situation is assessed by compiling simplified versions of financial statements including balance sheets and income statements. A personal balance sheet lists the values of personal assets (e.g., car, house, clothes, stocks, bank account), along with personal liabilities (e.g., credit card debt, bank loan, mortgage). A personal income statement lists personal income and expenses.
Goal setting: Having multiple goals is common, including a mix of short- and long-term goals. For example, a long-term goal would be to "retire at age 65 with a personal net worth of $1,000,000," while a short-term goal would be to "save up for a new computer in the next month." Setting financial goals helps to direct financial planning. Goal setting is done with an objective to meet specific financial requirements.
Plan creation: The financial plan details how to accomplish the goals. It could include, for example, reducing unnecessary expenses, increasing the employment income, or investing in the stock market.
Monitoring and reassessment: As time passes, the financial plan is monitored for possible adjustments or reassessments.
Typical goals that most adults and young adults have are paying off credit card/student loan/housing/car loan debt, investing for retirement, investing for college costs for children, paying medical expenses.
Personal finance principles
Personal circumstances differ considerably, with respect to patterns of income, wealth, and consumption needs. Tax and finance laws also differ from country to country, and market conditions vary geographically and over time. This means that advice appropriate for one person might not be appropriate for another. A financial advisor can offer personalized advice in complicated situations and for high-wealth individuals, but University of Chicago professor Harold Pollack and personal finance writer Helaine Olen argue that in the United States good personal finance advice boils down to a few simple points:
Look for low-cost, diversified mutual funds that balance risk vs. reward appropriately to your target retirement year
If using a financial advisor, require them to commit to a fiduciary duty to act in your best interest
Advocate for government social insurance programs
The limits stated by laws may be different in each countries; in any case personal finance should not disregard correct behavioral principles: people should not develop attachment to the idea of money, morally reprehensible, and, when investing, should maintain the medium-long term horizon avoiding hazards in the expected return of investment.
Areas of focus
Key areas of personal financial planning, as suggested by the Financial Planning Standards Board, are:
Financial position: is concerned with understanding the personal resources available by examining net worth and household cash flow. Net worth is a person's balance sheet, calculated by adding up all assets under that person's control, minus all liabilities of the household, at one point in time. Household cash flow totals up all the expected sources of income within a year, minus all expected expenses within the same year. From this analysis, the financial planner can determine to what degree and in what time the personal goals can be accomplished.
Adequate protection: or insurance, the analysis of how to protect a household from unforeseen risks. These risks can be divided into liability, property, death, disability, health and long-term care. Some of these risks may be self-insurable while most will require the purchase of an insurance contract. Determining how much insurance to get, at the most cost effective terms requires knowledge of the market for personal insurance. Business owners, professionals, athletes and entertainers require specialized insurance professionals to adequately protect themselves. Since insurance also enjoys some tax benefits, utilizing insurance investment products may be a critical piece of the overall investment planning.
Tax planning: typically, the income tax is the single largest expense in a household. Managing taxes is not a question whether or not taxes will be paid, but when and how much. The government gives many incentives in the form of tax deductions and credits, which can be used to reduce the lifetime tax burden. Most modern governments use a progressive tax. Typically, as one's income grows, a higher marginal rate of tax must be paid. Understanding how to take advantage of the myriad tax breaks when planning one's personal finances can make a significant impact.
Investment and accumulation goals: planning how to accumulate enough money for large purchases and life events is what most people consider to be financial planning. Major reasons to accumulate assets include, purchasing a house or car, starting a business, paying for education expenses, and saving for retirement.
Achieving these goals requires projecting what they will cost, and when one needs to withdraw funds. A major risk to the household in achieving their accumulation goal is the rate of price increases over time, or inflation. Using net present value calculators, the financial planner will suggest a combination of asset earmarking and regular savings to be invested in a variety of investments. In order to overcome the rate of inflation, the investment portfolio has to get a higher rate of return, which typically will subject the portfolio to a number of risks. Managing these portfolio risks is most often accomplished using asset allocation, which seeks to diversify investment risk and opportunity. This asset allocation will prescribe a percentage allocation to be invested in stocks, bonds, cash and alternative investments. The allocation should also take into consideration the personal risk profile of every investor, since risk attitudes vary from person to person.
Retirement planning is the process of understanding how much it costs to live at retirement, and coming up with a plan to distribute assets to meet any income shortfall. Methods for retirement plan include taking advantage of government allowed structures to manage tax liability including: individual (IRA) structures, or employer sponsored retirement plans.
Estate planning involves planning for the disposition of one's assets after death. Typically, there is a tax due to the state or federal government when one dies. Avoiding these taxes means that more of one's assets will be distributed to their heirs. One can leave their assets to family, friends or charitable groups.
Delayed gratification: Delayed gratification, or deferred gratification is the ability to resist the temptation for an immediate reward and wait for a later reward. For creation of personal wealth this is one of the key. .
Cash Management: It is the soul of your financial planning, whether you are an employee or planning your retirement. It is a must for every financial planner to know how much he/she spends prior to his/her retirement so that he/she can save a significant amount. This analysis is a wake-up call as many of us are aware of our income but very few actually track their expenses.
Revisiting Written Financial Plan Regularly: Make it a habit to monitor your financial plan regularly. An annual review of your financial planning with a professional keeps you well-positioned, and informed about the required changes, if any, in your needs or life circumstances. You should be well- prepared for all sudden curve balls that life inevitably throws in your way.
Education Planning: With the growing interests on students' loan, having a proper financial plan in place is crucial. Parents often want to save for their kids but end up taking the wrong decisions, which affect the savings adversely. We often observe that, many parents give their kids expensive gifts, or unintentionally endanger the opportunity to obtain the much-needed grant. Instead, one should make their kids prepare for the future and support them financially in their education.
Education and tools
An example of personal budget planning software
According to a survey done by Harris Interactive, 99% of the adults agreed that personal finance should be taught in schools. Financial authorities and the American federal government had offered free educational materials online to the public. However, according to a Bank of America poll, 42% of adults were discouraged while 28% of adults thought that personal finance is a difficult subject because of vast amount of information available online. As of 2015, 17 out of 50 states in the United States requires high school students to study personal finance before graduation. The effectiveness of financial education on general audience is controversial. For example, a study done by Bell, Gorin and Hogarth (2009) stated that those who undergo financial education were more likely to use a formal spending plan. Financially educated high school students are more likely to have a savings account with regular savings, fewer overdrafts and more likely to pay off their credit card balances. However, another study was done by Cole and Shastry (Harvard Business School, 2009) found that there were no differences in saving behaviours of people in American states with financial literacy mandate enforced and the states without a literacy mandate.
One thing to consider with personal finance and net worth goals is depreciating assets. A depreciating asset is an asset that loses value over time or with use. A few examples would be the vehicle that a person owns, boats, and capitalized expenses. They add value to a person's life but unlike other assets they do not make money and should be a class of their own. In the business world, for tax and bookkeeping purposes, these are depreciated over time due to the fact that their useful life runs out. This is known as accumulated depreciation and the asset will eventually need to be replaced.
^ abcdefgTahira, K. Hira (1 December 2009). "Personal finance: Past, present, and future". Social Science Research Network. Iowa State University - Department of Human Development and Family Studies: 4-16. SSRN1522299.
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