Personal Finance
Financial status is generally viewed with four basic quadrants.
- Income
- Expense (Spending)
- Assets
- Liabilities
One has to manage these four quadrants in a way that they can survive today and also in the future (ie after retirement). The way one manages these four quadrants:
Generating Income
Taxes
Spending
This module reviews spending in your life. It covers way to control spending and the ways to best enjoy what you do spend.
Insurance
Liabilities
This module reviews liabilities in your life. Liabilities by definition generates an expense (or spending). As you might see from the following list these are causes of the out flow of money.
Saving
Saving in view of personal finance is more of the discipline. A small amount of money saved regularly can build bigger kitty. This is because of compounding interest. The earlier you start to save, the more interest your money will gain over time if you don't touch your savings. In general savings can be classified by the purpose for which it is done.
The first purpose of saving is for saving rainy day. Based on the individual he/she needs to identify the amount which will be needed on short notice in case of emergency. This saving amount must be available in a bank account in such a way that you can withdraw at your will. Once you are saving beyond this amount it must become part of your investment. Second purpose for saving is that once you retire, the person has hopefully saved enough money to live on. The third purpose of saving is to leave a legacy to a family member or a friend. A legacy is where a person saves up money and when they die, the money goes to the family member.
Investing
Investing involves using your money (or borrowed money that you control) to earn more money. Investments are classified based on the risk and return matrix. Most people base their investments on how soon they expect to retire, how long they want that money to last, and how they want to live after they retire. The average retired person that has money invested plans on really never touching the money invested but rather living off the interest their money is making them. For example, if a person is retired and wants to live off $50,000 for the rest of their life, they might have 1 million dollars invested trying to earn 5% on the investments. That way at the end of the year they have made 50,000 which can be withdrew and they still have that 1 million dollars invested.
Following are the possible categories :
High Risk = High Return
This formula is stating that a person that is willing to invest in riskier assets expects a higher return on those assets. A good example of high risk investments are:
Single stocks Small cap stocks Large cap stocks Volatile stocks
Low Risk = Low Return
This formula is showing that a person that want to have safe guaranteed investments show expect a low return. People that usually invest in safer options tend not to trust the market and have considerable doubts.
Examples of low risk options are: Mutual funds (diversified with stock and bonds) Treasury bills Triple A rated bonds
In general one should be able to put their investment in above two class. A person doesn't want to put all of their money into investments. Most people want a safety net so they should keep a certain percent of their money in cash. The best thing an investor can do for retirement planning is to diversify their portfolio (don't put all your eggs in one basket). Diversifying a portfolio makes is less risky to the investor but can still have a decent return. This is because the investor can expect the total percentage of your portfolio not to change has much as one stock alone.
Ratio in which one's investment should be distributed between the two categories is based on the person's risk appetite. One's risk apatite can be a function of age and total assets. If a person is younger, he/she can invest more in riskier avenues since he/she can recover from the loss. If the person already has very high assets he can increase his/her exposure to the riskier investments to gain more returns. If a person is already retired, they might want to consider investing in safe investments that produce a low guaranteed income because they don't have any other source of income coming in so they wont want to take the chance on losing it.
