What is Personal Finance?
Let’s begin with a definition.
“Personal finance is the financial management which an individual or a family unit performs to budget, save, and spend monetary resources over time, taking into account various financial risks and future life.” – Wikipedia
In simple terms, personal finance is the proactive management of one’s finances; including one’s earning, spending and savings. In spiritual terms, personal finance is the key to achieving financial freedom, to wealth creation; the road to financial nirvana.
Personal Finance is one the highest-leverage skills that we should all build throughout our lifetimes. It gives us insight into our financial behaviours, allows us to maximize our return on investment, and empowers us to become captains of our financial future.
The Goal of Personal Finance
“Finance is not merely about making money. It’s about achieving our deep goals and protecting the fruits of our labor. It’s about stewardship and, therefore, about achieving the good society.” – Robert J. Shiller
The fundamental goal of personal finance is to create and accumulate wealth. In this case, wealth represents the surplus of financial assets and income; enough to cover one’s living expenses, desires and pleasures. Financial literacy empowers us to manage the financial aspects of our lives, to control our expenses, and to take the steps to providing for ourselves in the future.
II: The Wealth Creation Cycle
Personal Finance management can be represented as a cycle, or a series of steps, that one must perform over time. The goal of the cycle is to build and accumulate individual wealth for long-term financial prosperity.
The Wealth Cycle follows four simple steps:
- Your hardwork, time and effort generate income.
- You live and enjoy life; spending and saving your income.
- You invest your savings with the goal of generating future returns.
- Your investments generate returns. You review your performance, adjust and repeat.
The above process may sound like an oversimplification, but it’s the simple cold truth. Managing one’s finances comes down to the simple decisions we make in our everyday lives. Building wealth requires disciplined action, sustained over time.
Let’s dive into each step in the cycle.
When we think of Income, the keyword is “Earning”.
What is Income?
- “Money that an individual or business receives in exchange for providing a good or service or through investing capital.” – Investopedia
- “Income is the sum of all the wages, salaries, profits, interests payments, rents, and other forms of earnings received… in a given period of time.” – Wikipedia
Income includes everything you earn; which is more than just your paycheque.
Types of Income
Earned income comes from active work; such as salary, benefits and perks, stock and equity, commissions and bonuses.
Unearned (portfolio) Income comes from investments; such as interests from savings accounts, bond interest, and stock dividends.
Passive Income comes from sources other than active work for an employer; such as rental properties, royalties, commission, and interest from investments.
Guidelines + Tips
A couple useful guidelines for thinking about generating income:
1) Good work is your best friend. Salary is what you receive in exchange for your time. When it comes to understanding your career income, there’s a simple cycle to keep in mind. The more value you add, the more opportunity and responsibility you will be given; the higher your financial compensation/reward.
2) Take a Holistic-Approach. An effective way to secure your long-term sustainability is by understanding all of the types of income generating activities and investments you can pursue. By developing multiple streams of income, you will achieve two things. First, your income generation will not depend on your time, which is the limiting factor of earned income. Second, you will reduce your risk and dependency on a single source of income.
3) Maximize your Earning Potential. The goal over time is to not only achieve predictable steady flow of income, but also to continuously increase the magnitude of your income flow. This can only be achieved thru proactive learning and continuous improvement sustained over a long time. As you become better at your craft, so will increase your earning ability or in simple terms your ‘market value’. You’ll be able to supply ‘higher quality work’ and demand higher compensation in return.
Saving + Spending
“Beware of little expenses. A small leak will sink a great ship.” – Benjamin Franklin
When we think of Saving and Spending, the keyword is “Living”.
It comes down to the costs of your lifestyle and the surplus leftover for future use.
- Expenses: “voluntary private consumption, or an exchange of money for goods and services.”
- Savings: “the amount left over when the cost of a person’s consumer expenditure is subtracted from the amount of disposable income he earns in a given period of time.”
- Budget: “an estimation of income and expenses over a specified future period of time.”
Guidelines + Tips
A couple useful guidelines for thinking about your budget, savings and spending:
1) Pay yourself first. Savings shouldn’t be optional. Paying yourself first means “automatically routing savings contributions to your investment account.” The cycle is simple. Earn. Save. Budget the rest.
2) Needs before wants. There is a fundamental difference between needs and wants. Needs are necessary for your daily living. Wants represent your guilty pleasures and desires. Cut the clutter and unnecessary spending.
3) Control your expenses. First, list and quantify your fixed costs; such as rent and utilities. Next, define spending categories and quantities; such as food, transportation and lifestyle. Now you’ll have a baseline on which to assess your spending behavior. Track your expenses periodically. Don’t break your own rules.
4) Spend less than you make. It turns out, most of us have more than we need. The key to financial freedom is long-term consistency in spending less than you make. This applies for businesses, companies, individuals and families. As long as you make more than you spend, you will always have a surplus, a little extra, that you can invest for the long-haul.
“Gold laboreth diligently and contentedly for the wise owner who finds for it profitable employment, multiplying even as the flocks of the field.” – The Richest Man in Babylon
When we think of Investment, the core idea is “Allocation”.
It comes down to building a portfolio of assets with our savings.
- Asset: “a resource with economic value that an individual, corporation or country owns or controls with the expectation that it will provide future benefit.”
- Investment: “an asset or item that is purchased with the hope that it will generate income or will be sold at a higher price for a profit.”
- Return: “the income and the capital gains relative on an investment, and it is usually quoted as a percentage.”
Types of Assets
It’s also important to understand that there are different types of assets:
Financial Assets: “a tangible liquid asset that derives value because of a contractual claim of what it represents.”
- Chequing and Savings Accounts (Cash)
- Certificate Of Deposit (CDs)
- Mutual, Index or Exchange Traded Funds
- Retirement Funds
Physical Assets: “an item of economic, commercial or exchange value that has a tangible or material existence.”
- Equipment and Machinery
- Inventory and Commodities
- Real Estate, Property, Land
Guidelines + Tips
The question to answer is “What should I do with my savings?”
1) Invest in assets that suit your goals and needs. Each asset has its own nature and characteristics. They will vary in terms of the returns they generate and their underlying risk. They will vary in terms of their liquidity, and the ability to convert them into cash. They will vary in terms of their investment horizon, short-term vs long-term. Understand your financial goals and priorities. Invest accordingly.
2) Diversify your portfolio to manage risk. According to Modern Portfolio Theory and the economist Harry Markowitz, “investors can reduce their exposure to individual asset risk by holding a diversified portfolio of assets”. The idea is that owning investments that are highly correlated leaves you exposed (vulnerable) to market volatility. By owning different types of investments, you can reduce your sensitivity to market swings, having the gains in one asset type offset the losses in another.
3) Get Professional Advice. Poor investment decisions can reduce a lifetime of hard-earned savings to nothing. The best thing an individual can do is seek the advice of a professional. The cost of failure is way too expensive and your odds of beating the market on limited information and part-time energy are slim to none.
When we think of Return, the key idea is “Measurement”.
The goal in this step is to streamline the review process, to gain clarity on our financial progress, and to understand the returns we are achieving on our investments.
- Income Statement: “a financial statement that reports a company’s financial performance over a specific accounting period.”
- Balance Sheet: “a financial statement that summarizes a company’s assets, liabilities and shareholders’ equity at a specific point in time.”
- Financial Ratios: “tools to evaluate the overall financial condition of a corporation or other organization.”
Guidelines + Tips
1) Employ a CFO-Mindset. Leverage the insights of financial ratios to define targets and measure your own performance. You want to run ‘yourself’ like a business and have your own scorecard or set of KPIs. Don’t leave high performance to luck.
2) Manage your cash flow using a Personal Income Statement. List out your monthly income streams, track your expenses, and calculate your savings. Preferably, you’ll have pre-spending savings that you took out BEFORE spending. If you’ve controlled your expenses, you’ll have a portion of your spending budget leftover to invest as well.
3) Measure your worth using a Personal Balance Sheet. Your Net Worth equals the sum of your Assets minus your Liabilities. This will help you understand your portfolio position and financial progress along your long-term goals.
4) Streamline the Process. This process should require time upfront to set up. Automate tracking and reporting as much as possible. Once in place, you should simply check-in periodically to review your performance and adjust as you see fit.
5) “Good Investing is Boring” – Adam Nash. Effective wealth creation requires a disciplined practice of personal finance as well as rigorous patience sustained over the long-term to allow for the exponential impact of compound interest.
Personal Income Statement
The Personal Income Statement tracks the monthly flow of income, expenses and savings. The Profitability KPIs included help understand what portions of the income were spent, how much was invested, and how much was leftover as a buffer for short-term uncertainty.
Personal Balance Sheet
The Personal Balance Sheet tracks all of your assets, liabilities, and your net worth. The Portfolio KPIs included help measure the growth and liquidity of the Portfolio over time.
III. Other Useful Concepts
A Long-Term Perspective
When it comes to taking on a long-term perspective, it’s crucial that we be as objective and rational as possible.
It’s easy to take an emotional approach to finance and investing, reacting to the latest hype and trend in the news. A long-term perspective implies being proactive and cautious in one’s actions, with the goal of prioritizing and maximizing long-term returns.
Motivation and Fulfillment
Maslow said it best. Humans are motivated by the pursuit and fulfillment of needs. By managing our finances and putting our money to work, we can guarantee the ability to satisfy our basic needs, and focus more of our time higher achieving higher levels of personal fulfillment.
The Power of Compounding
“Compound interest is the most powerful force in the universe.” – Albert Einstein
Simple defined, compound interest represents the “interest calculated on the initial principal and also on the accumulated interest of previous periods of a deposit or loan.” Compound interest allows you to reinvest your earnings into your principal and increase your gains over time, by gaining interest on the interests received previously.
Compound interest is the key to exponentially growing your investments over time. Leveraging the power of compound interest requires time and patience. A long-term perspective is necessary to avoid the temptation of short-term spending, and to enable exponential growth to take its course.
The Rule of 72
The rule of 72 states that we can estimate the time required to double our investments, by dividing our compound annual interest rate into the number 72.
Example: An investment earning 5% interest will take 14.4 years (72 / 5) to double.
While this may time period may sound daunting, it once again justifies the importance of taking a long-term perspective when it comes to investing. There are no shortcuts.
Two Cycles in Sync
Combining the principles of our cash flow and investment portfolio, we see two interdependent cycles occurring over time.
Monthly Cash Flow Cycle
- Our hard work, time, and investments generate income.
- Part of our income is consumed and spent to cover our lifestyle.
- Part of our income is saved, and leftover to be invested.
Investment Portfolio Cycle
- We invest our surplus income (savings) into a variety of assets.
- These assets produce different returns. We measure their performance.
- We make adjustments, rebalance or re-invest to better meet our financial goals.
IV. In Conclusion
The road to financial freedom is a long one and challenging one. The goal of this guide is to provide you with an understanding of some of the core concepts of Personal Finance and to provide you the tools to gain control of your financial life.
By now you should have the confidence and ability to:
- Understand the mechanics of income, expenses, savings, investments, compounding.
- Leverage tools such as Income Statements, Balance Sheets and Financial Ratios.
- Gain control of your personal finances. Build a cycle of personal wealth creation.
V. One Last Thing
As a parting gift, I leave with you the Five Laws of Gold, from George Clason’s classic, “The Richest Man in Babylon”:
I. Gold cometh gladly and in increasing quantity to any man who will put by not less than one-tenth of his earnings to create an estate for his future and that of his family.
II. Gold laboreth diligently and contentedly for the wise owner who finds for it profitable employment, multiplying even as the flocks of the field.
III. Gold clingeth to the protection of the cautious owner who invests it under the advice of men wise in its handling.
IV. Gold slippeth away from the man who invests it in businesses or purposes with which he is not familiar or which are not approved by those skilled in its keep.
V. Gold flees the man who would force it to impossible earnings or who followeth the alluring advice of tricksters and schemers or who trusts it to his own inexperience and romantic desires in investment.
Now let’s get to work and put our gold (time and energy) to good use.
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