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Ten Principles of Personal Finance

| March 15, 2017
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The following list is adapted from the ten principles of personal finance by Arthur J. Keown in his book, Personal Finance, Turning Money Into Wealth.

1. Knowledge is Power

Finding advice is not hard. Finding good advice can be. The world is full of articles, videos, books, self-proclaimed gurus, financial advisers, consultants, representatives, etc. all trying to give you advice on what to do with your money. Every single one of these resources has the potential to be filled with bias, misleading or false information, or just flat out bad advice. So how can you protect yourself from all of this? It all starts with knowledge.

It's unreasonable to expect yourself to be an expert on every area of personal finance, but that doesn't mean that you shouldn't make an effort to be informed. Learning the basics of personal finance will help you to make better decisions and:

  • Identify information that applies to you and to ignore information that doesn't. Sometimes the information and advice aren't bad, they just don't apply to you specifically.
  • Allow you to partner with professionals in planning for your future, rather than leaving it up to them to do it for you
  • Give you an understanding of the urgency and importance of planning for your future.
  • Protect you from incompetent and/or biased financial professionals and information. When you arm yourself with knowledge, you can better identify people and information that may not have your best interest at heart.

2. Nothing Happens Without a Plan

People are creatures of defaults. We tend to take the easy path until we are motivated enough, either by fear or desire, to change. For many of us, our default lifestyle would be quite passive, lacking the discipline to exercise and eat healthily. It is only when we have cringed enough looking in the mirror, been motivated by someone else, or seen the poor effects of an unhealthy lifestyle on ourselves or someone we know, that we are motivated to change.

The same logic can be applied to financial planning. No one wakes up one morning and says to themselves, "You know what I want to do today? Delve into the ball of insecurity that is my financial situation and try to make that into an actionable plan for my future goals." Nope. No one. Why? Because it's not our default! Our default is to ignore it because that's easier. We put it out of mind until we experience enough incentive to get us moving, whether positive or negative. Don't let idleness be your default. 

3. The Time Value of Money

When idleness is your default for long enough you start to miss out on this next important principle, the time value of money.

Time is always working for or against your money. Its is working for you in your investments and against you in your debts. Believe it or not, even that dollar wedged under your mattress is slowly losing value. Don't believe me? Look at the Consumer Price Index over the past 70 years. Everything just keeps getting more expensive, while your mighty mattress dollar gets less and less valuable.

However, time isn't always a drag, it can be exciting as well. For example, if you invested $200 per month for 40 years, growing at a compounded rate of 10% each year, you would have over $1.25 million dollars at the end of that period. You would have only invested $96,000 over that 40 years, the rest of that $1.25 million dollars is compounded interest plus a whole lot of time. 

Sounds great, right? So why doesn't everyone do that? This leads to our next principle, risk vs. return.

4. Risk vs. Return

There aren't many areas in which the phrase, "nothing ventured, nothing gained" is more applicable than in finance. There is a general relationship between the amount of risk taken and the amount of return on your investment that you will expect. No one in their right mind would take on more risk if there were not more to be gained. 

What do we mean when we say risk? There are many types of investment risk. Below are the two main types of investment risk:

  • Business Risk- This can also be referred to as company, industry-specific, or unsystematic risk. It is merely the risk that a specific company, or even the company's industry as a whole, will do poorly or fail. This is one type of risk that can be reduced through diversification.
  • Market Risk- This is also referred to as systematic risk. It is the risk that is inherent to the market and all the securities in it as a whole. This is one type of risk that cannot be mitigated by diversification. No matter how diversified you are, you cannot completely eliminate the risk associated with investing.

There are many other types of risk to consider, such as credit, inflation, liquidity, social, currency, legislative, etc. In short, with investing comes risk, and every person is different in regard to their tolerance of risk.

5. Taxes Matter

You can't just evaluate an investment purely in terms of expected return; you have to keep taxes in mind. A rule of thumb is that, sooner or later, Uncle Sam always gets paid. You should always be mindful of the effect taxes will have on your investment, both now and in the future. It may very well change how or what you invest in.

6. Life Happens - The Importance of Liquidity

If financial planning guarantees a single thing, it's that you will be wrong. Even the most meticulously created financial plan will be based upon assumptions that will change given enough time. Does this mean that you shouldn't even try to plan for the future? Of course not! However, you should not plan for your long and intermediate-term goals at the expense of your short-term stability.

Enter the emergency fund. You should always have some of your money available at a moment's notice, a term we refer to as liquidity. A general rule of thumb is that you should have 3 to 6 months in liquid funds available to meet emergencies or unexpected needs, such as a job loss, medical need, car troubles, home repair, etc.

7. The Power of Budgeting

"A penny saved is a penny got" (yes, this is the actual quote from Ben Franklin).

This one is simple. Know what you make, and know what you spend. Can you name a Fortune 500 company that isn't aware of their cash inflows and outflows? Set goals for yourself and cultivate the discipline to systematically work towards them. 

8. Protect Yourself and Others

Insurance. The thing no one is excited to buy, but everyone has. The worst time to worry about your insurance coverage is after a tragedy has occurred. Do yourself and loved ones a favor and evaluate your health, life, disability, property & casualty, and long-term care insurance needs and put a plan in place sooner rather than later. Especially do your homework before someone comes knocking on your door to try to sell you some. Insurance is one of the most necessary aspects of your financial picture, but it is also one of the most abused. This goes back to principle #1: Arm yourself with knowledge and make an educated decision.

9. You Are Your Worst Enemy

I just finished a book called, "The Little Book of Behavioral Investing: How not to Be your Own Worst Enemy" by James Monier. If you're interested in exploring this concept more fully, I highly recommend it. The premise of the book is simple: overcoming human instinct and emotion is key to becoming a better investor. The biggest risk to your future financial success is not inflation, pushy salesmen, poor 401(k) investing options, nor taxes. Your biggest risk is yourself. 

According to a study done by Dalbar, from 1983 to 2013, the market, as measured by the S&P 500 averaged 11.11% per year, but the average individual investor earned only 3.69%. 

Don't fall victim to overconfidence, fear, media noise, so-called "gurus," emotional decisions, nor the goals of other people.

10. Just Do It!

The most difficult step in the entire planning process is implementation. The actual act of getting started and maintaining the course is the biggest obstacle for most. As a perfectionist at heart, I can struggle with this principle in many areas of my life. If I feel that everything is not perfect before I begin, I tend to not even attempt the endeavor. I once spent an entire day trying to formulate the "perfect workout routine," all the while sitting on my couch. Planning is a vital step, but don't get stuck there forever. Eventually, the rubber has to meet the road.

Resources

Keown, A. J. (2010). Personal finance: turning money into wealth. Boston: Pearson.

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