CHAPTER 1

Personal Financial Planning

 Introduction
• Bryon and Tomika are just one semester shy of graduating from
a state college.Bryon is getting a degree in protective services
and is thinking of going for certification as fire protetion engineer,
which would cost an additional $4,500. With his protective
services degree many other fields will be open to him as well-
from first responder to game warden oor correctional officer.
Bryon will have to specialize immediately and wants a job in his
state that comes with some occupational safety and lot of job
security.
 1.1 Individual or ‘’ Micro’’ Factors That Affect Financial
Thinking

LEARNING OBJECTIVE

1. list Individuals factors that strongly influence

financial thinking.
2. Discuss how income, income needs, risk
tolerance, and wealth are affected by individual
factors.
3. Explain how life stages affect financial decision
making.
• The circumstances or characteristics of your life
influence your financial concerns and plans. What you
want and need-and how and to what extent you want to
protect the satisfaction of your wants and needs-all
depend on how you live and how you’d like to live in the
future. While everyone is different, there are common
circumstances of life that affect personal financial
concerns and thus affect everyone’s financial planning.
Factors that affect personal financial concerns are family
structure, health, career choices, and age.
 Family Structure

• Marital status and dependents, such as children,

parents, or siblings , determine whether you are
planning only for yourself or for others as well. if you
have a spouse or dependents, you have a financial
responsibility to someone else, and that includes a
responsibility to include them in your financial thinking.
You may expect the dependence of a family member to
end at some point, as with children or elderly parents, or
you may have lifelong responsibilities to and for
another person.
• Partners and dependents affect your
financial planning as you seek to provide for
them, such as paying for children’s
education. Parents typically want to protect
or improve the quality of life for their
children and may choose to limit their own
fulfillment to achieve that end.
• Providing for others increases income needs.
Being responsible for others also affect your
attitudes toward and tolerance of risk. Typically
both the willingness and ability to assume risk
dimishes with dependents, and a desire for more
financial protection grows. people often seek
protection for their income assets even past their
own lifetimes to ensure the continued well-being
of partners and dependents.
 Health
• Your health is another defining circumstance that will
affect your expected income needs a risk tolerance and
thus your personal finance planning. Personal fianancial
planning should include some protection against the risk
of chronic illness, accident, or long-term disability and
some provision for short-term events, such as pregnancy
and birth. If your health limits your earnings or ability to
work or adds significantly to your expenditures, your
income.
 Career Choice
• Your career choices affect your financial planning, through educational
requirements, income potential, and characteristics of the occupation or
profession you choose. Careers have different hours, pay, benifits, risk
factors, and patterns of advancement over time. Thus, your financial
planning will reflect the realities of being a postal worker, professional
athlete, commissioned sales representative, corporate lawyer, freelane
photographer, librarian, building contractor, tax preparer, professior, Web
site designer, and so on. For example, the careers of most athletes end
before middle age, have higher risk of injury, and command steady, highe-
than-average incomes, while the careers of most sales representativea last
longer with greater risk of unpredictable income fluctions. Figure 1.1
‘’Median Salary Comparison by Profession’’ compares the median
salaries of certain careers.
Figure 1.1 Median Salary Comparisons by Profession Based on data from
http://www.careeroverview.com/salary-benefits.html ( accessed November 21,2009).
PROFESSION MEDIAN SALARY
Account 54,600
Personal Financial 66,100
Sports Competitor 41,100
Interior Designer 42,300
Substance Abuse Social Worker 35,400
Computer Programmer 65,500
Elementary School Teacher 45,600
Cafeteria Cook 20,400
Dentist 132,000
Pharmacist 94,500
Lawyer 102,500
Sales Manager 91,600
Fire Fighter 41,200
Lab Technician 32,800
Most people begin their independent financial lives by selling their labor to
create an income by working.Over time they may choose to change careers,
develop additional sources of concurrent income, move between employment
and self-employment, or become unemployed or reemployed. Along with
career choices, all these changes affect personal financial managment and
planning.

Age

Needs, desire,values,and priorities all change over a lifetime, and financial

concerns change accordingly, Ideally, personal finance is a process of
management and planning that anticipate or keeps abreast with changes.
Although everyone is different, some financial concerns are common to or
typical of the different stages of adult life. Analysis of life stages is part of
financial planning.

At the beginning of your adult life, you are more likely to have no dependents,
little if any accumulated wealth, and few assets. (Assets are resources that
As a young adult you also are likely to have comparatively small income
needs, especially if you are providing only for yourself. Your employment
income is probably your primary or sole source of income. Having no one and
almost nothing to protect, your willingness to asume risk is usually high. At
this point in your life, you are focused on developing your career and
increasing your earned income. Any investment you may have are geared
toward growth.

As your career progresses,income increases but so does you now have a

spouse and dependents and elderly parents to took after, you have additional
needs to manage. In Middle adulthood you may also be acquiring more assets
as a house, a retirement account, or an inheritance.

As income, spending, and asset base grow, ability to assume risk grows, but
wilingness to do so typically decreases. Now you have things that need
protection: dependents and assets. As you age, you realize that you require
more protection. You may want to stop working one day, or you may suffer a
decline in health. As an older adult you may want to create alternative
Figure 1.3 Financial Decisions Related to life Stages
Young Middle Older
Adulthood Adulthood Adulthood Retirement

Source of Wages Wages/ Wages/ Investment

Income Investment Investment
Asset base None Accumulating Growing Using up

Expenses Low Growing Growing Low

Risk: Low higher Higher High

Ability
Risk: High Lower Lower Low
Willingness

Early and middle adulthoods are periods of building up: building a family,
building a career, increasing earned income, and accumulating assets.
Spending needs increase, but so do investments and alternative sources of
income.
Later adulthood is a period of spending down. There is less reliance on
earned income and more on the accumulated wealth of assets and
investments. You are likely to be without dependents,as your children have
grown up or your parents passed on, and so without the responsibility of
providing for them, your expenses are lower, You are likely to have more
liesure time, especially after retirement.

Without dependents, spending needs decrease. Om the other hand, you may
feel free to finally indulge in those things that you’ve ‘’alaways wamted.’’
There are no longer dependents to protect, but assets demand even more
protection as, without employment, they are your only soure of income.
Typically, your ability to assume risk is high because of your accumulated
assets, but your willingness to assume risk is low, as you are now dependet
on those assets for income. As a result, risk tolerance decreases; you are less
concerned with increasing wealth than you with protecting it.
* Personal circumstances that influence financial thinking include
family structure, health career choice, and age.

* Family structure and health affect income needs and risk

tolerance.

* Career choice affects income and wealth or asset accumukatin,

spending needs, and risk tolerance.

* Sound personal financial planning is based on through

understanding of your personal circumstances and goals.
1.2 Systemic or ‘’Micro’’ Factors That Affect Financial
Thinking
LEARNING OBJECTIVES

1. Identify the systematic or macro factors that affect personal financial planning.

2.Describe the impact of inflation or deflation on disposable incom.

3.Desribe the effect of rising unemploymenton disposable income.

4.Explain how economic indicators can have an impact on personal finances.

Financial planning has to take into acccout conditions in the wider economy
and in the markets that make up the economy. The labor market, for
example, is where labor is traded through hiring or employment Workers
compete for jobs and employers compete for workers. In the capital market,
capital ( cash or assets) is traded, most commonly in the form of stocks and
bonds (along with other ways to package capital). In the credit market, a
part of the capital market, capital is loaned and borrowed rather than bought
and sold. These and other markets exist in a dynamic economic
environment,and those environmental realities are part of sound financial
planning.

In the long term, history has proven that an economy can grow over time, that
investments can earn returns, and that the value of currency can remain
relatively stable. In the short term, however, that is not continously true.
Contary or unsettled periods can upset financial plans, especially if they lat
long enough or happen at just the wrong time in your life. Understanding
large-scale economic patterns and factors that indicate the health of ajn
Bussiness Cycles

An economy tends to be productive enough to provide for the wants of

its members. Normally, economic output increases as population
increases or as people’s expectations grow. An economy’s output or
productivity is measured by its gross domestic product or GDP, the
value of what is produced in a period. When the GDP is increasing, the
economy is inan expansion, and when it is decreasing, the economy is
in a contraction.
Figure 1.4 GDP Percent Change (Based on Current Dollars) Based on data from the bureau of Economic Analysis, U.S.
Department of Commerce, http://www.bea.gov/national/ ( accessed November 21, 2009).
Over time, the economy tends to be cyclical, usually expanding but sometimes
contracting. This is called the business cycle. Periods of contraction are generally seen
as market corrections, or the market regaining its equilibrium, after periods of Growth. is
never perfectly amooth, so sometimes certain markets become unbalanced and need to
correct themselves. Over time, the periods of contraction seen to have become less
frequent, as you can see in Figure 1.4 ‘’GDP Percent Change (Based on Current
Dollars)’’ The business cycles still occur neverthless.

There are many metaphors to describe the cyclical nature of market ecnomies: ‘’peaks
and troughs,’’ ‘’boom ajnd bust,’’ growth and contraction,’’ ‘’expansion and correction,’’
and so on. While each cycle is born in a unique combination of circumstances, cycles
occur because things change and upset economic equilibrium. That is, events change
the balance between suppy and demand in the economy overall. Sometimes demand
grows too fst and supply can’t keep up, and sometimes suppy grows too fast for
demand. There are many reasons that this could happen, but whatever the reasons,
buyers and sellers react to this imbalance, which then creates a change.
 Employment Rate
An economy produces not just goods and services to satisfy its members but also jobs,
because most people participate in the market economy by trading their labor, and most rely
on wages as their primary source of income. The economy therefore must provide
opportunity to earn wages so more poeple can participate in the economy throught the
market. Otherwise, more people must be provided for in some other way, such as a private or
public subsidy (charity or welfare).

The unemployment rate is a measure of an economy’s shortcomings, because it show the

proportion of people who want to work but don’t because the economy cannot provide them
jobs. There is always some so-called natural rate of unemployment as people move in and
out of the workforce as the circumstances of their live change-for example, as they retrain for
a new career or take time out for family. But natural unemployment should be consistently
low and not affected the productivity of the economy.

Unemployment also shows that the economy is not efficient, because it is not able to put all
its productive human resources to work.
A healthy market economy uses its labor productively, is productive, and
provides employment opportunities as well as consumer satisfaction through
its markes. Figure 1.6 ‘’Cyclical Economics Effects’’ shows the
relationship between GDP and unemployment and each stage of the business
cycle. Boom Expansion

Rate of GDP Unsustainably Positive Negative Unsustainably

Incease High Low

Rate of Unsustainably ‘’Natural’’ Higher Unsustainably

Unemployment Low or Minimal High

At either end of this scale of growth, the economy is in an unsustainable

position: either growing too fast, with too much demand for labor, or
shrinking, with too little demand for labor.
If there is too much demand for labor-more jobs than workers to fiil them-
then wages will rise, pushing up the cost of everything and causing prices to
rise: Prices usually rise faster than wages, for many reasons, which would
discourage consumption that would eventually discourage production and
cause the economy to slow down from its ‘’boom’’ condition into a more
manageable rate of growth.

If there is too little demand for lafbor-more workers than jobs-then wages fail
or, more typically, there will be people without jobs, or unemployment. If
wages become low enough, employers theorerically will be encourage to hire
more labor, which would bring employment levels back up. However, it
doesn’t always work that way, because people have job mobility-they are
willingness and able to move beetween economies to seek employment.

If unemployment is high and prolonged, then too many people are without
wages for too long, and they are not able to participate in the economy
because they have nothing to trade. In that case, the market economy is just
not working for too many people, and they will eventually demand a change
 Other Indicators of Economic Health
Other economic indicators give as clues as to how ‘’successful’’ our economy is, how well it is
growing, or how well positioned it is for future growth. these indicators include statistics,
such as the number of houses being built or existing home sales, orders for durable ggods
(e.g., appliances and automoiles), consumer confidence, producer prices, and so on.
However, GDP growth and unemployment are the two most closely watched indicators,
because they get at the heart of what our economy is supposed to accomplish: to provide
diverse opportunities for the most people to participate in the economy, to create jobs, and
to satisfy the consumption needs of the most people by enabling them to get what they
want.

An expanding and healthy economy will offernmore choices to participants: more choices for
trading labor and for trading capital. It offers more opportunities to earn a return or an
income and therefore also offers more diversification and less risk.

Naturally, everyone would rather operate in a healthier economy at all times, but this is not
always possible. Financial planning mustbinclude planning for the risk that economic factors
will affect financial realities. A recession may increase unemployment, lowering the return on
labor-wages-or making it harder to anticipate an increase in income. Wage income could be
A bedge against lost wages is investment to create other forms of
income. In a period of economic contraction, however, the
usefulness of capital, and thus its value, may decline as well. Some
businessnand industries are considered immune to economic
cycles (e.g., public education and health care), but overall,
investment returns may suffer. Thus, during your lifetime business
cycles will likely affect your participation in the capital markets as
well. CURENCY VALUE
Stable currency value is another important indicator or financial
planning. Like anything else, the value of a currency is based on its
usefulness. We use currency as a medium of exchange, so the
value of a currency is based on how can be used in trade, which in
turn is based on what is produced in the economy. If an economy
produces little that anyone wants, then its currency has little value
relative to other currencies, because there is little use for it in
trade. So a currency’s value is an indicator of how productive an
A curreny’s usefulness is based on what it can buy, ornits purchasing power. The more a
currency can buy. the more useful and valuable it is. When prices rise or when things cost
more, purchasing power decreases; the currency buys less and its value decreases.

When the value of a currency decreases, an economy has inflation. its currency has less
value because it is less useful; that is less can be bought with it. Prices are rising. It takes
more units of currency to buy the same amount of goods. When the value of a currency
increases, on the other hand, an economy ha deflation. Prices are falling; the currency is
worth more and buys more.

For example, say you can buy five video games for $20. Each game is worth $4, or each
dollar buys 1/4 of a game. Then we have inflation, and prices-including the price of video
games-rise. A year later you want to buy games, but now your $20 only buys to games. Each
one costs $10, or each dollar only buys one-tenth of a game. Rising prices have eroded the
purchasing power of your dollars.

If there is deflation, prices fall, so maybe a year later you could buy ten video games with
your same $20. Now each game costs only $2, and each dollar buys half a game. The same
amount of currency buys more games: its purchasing power has increased, as has its
usefulness and its value (Figure 1.7 ‘’ Dynamic of Currency Value’’).
Figure 1.7 Dynamics of currency Value

Inflation Deflation

Prices Rise Fall

Purchasing Decreaes Increases

Currency Falls Rises

Value

Inflation is most commonly measred by the consumer price index (CPI), an

index created and tracked by the federal government. It measres the average
nationwide prices of a’’basket’’ of goods and services purchased by the
average consumer. It is an accepted way of tracking rising or falling price
levels, indicative of inflation or deflation. Figure 1.9 ‘’ Inflation,1979-
2008’’ shows the percent change in the consumer price index as a measure
of inflation during the period from 1779 to 2008.
Figure 1.9 Inflation,1979-2008 Based on data from the Bureau of Labor Statistics, U.S. Department of Labor,
http://ww.bls.gov accessed (accessed November 21,2009).