Week 1 - personal financial planning process

The purchasing power of money usually?

decreases

What do you use to measure the changes in price?

CPI

The price of goods

stayed stable in between 2003 -2020. After covid the price increased

Personal financial planning

Process of meeting your life goals through management of your finances

What is the personal financial planning process

1. Analyse your current finances

2. Develop goals

3. Identify and evaluate strategies to achieve your goals

4. Establish and implement your plan

5. Reevaluate and revise your plan as needed

4 elements of a personal financial plan

• Establish foundation - what do I need to know, to do, the tools, my objectives?

• Secure basic needs - cashflow, housing, employment choices, emergency funds

• Build wealth - save, invest

• Protect finances - insurance, estate planning

Financial planning involves making effective decisions

1. Use reasonable assumptions

2. apply marginal reasoning

3. consider opportunity costs

4. use sensitivity analysis

Financial planning involves making effective decisions - use reasonable assumptions

Plans contemplate possibilities - be reasonable but contemplate the extreme outlier

Financial planning involves making effective decisions - apply marginal reasoning

• What changes because of your decision?

• What changes "at the margin"?

  • If an income or expense doesn’t change because of my choice, than that income/expense isn’t marginal - why is it relevant?

What is a sunk cost?

a cost that is irreversible and can't recover it, past. Sunk cost is not marginal

Financial planning involves making effective decisions - consider opportunity costs

• What have you given up doing?

• What are you missing out on?

• What else could you have done?

Stage 1 of PFP - Assess your finances

• Two types of information we can assess your finances with

financial position/net worth (personal balance sheet) and financial performance (personal cash flow statement)

personal balance sheet

• This is the history of what has happened. Over previous months/years

Personal cash flow statement

Shows what is happening this month/year

• Working out your net worth

• Compare what you own (assets) against what you owe (liabilities)

What is the most valuable assset?

human capital (ourselves)

What is human capital?

ability to earn and save

simple relationship between your human capital and your financial capital - Levels of human capital

• Human capital is highest when you are younger and decreases throughout your life

• By retirement you would have used most of your human capital

When you work you are converting human capital to

financial capital

simple relationship between your human capital and your financial capital - Levels of financial capital

• Financial capital is higher later in life

• After retirement financial capital decreases as this is our only financial resource

A model of income & wealth over the life cycle

• When you start work you save during work

• Need higher income than expenditure so can save

• Accumulate wealth and this peaks at retirement

• When retire, wealth reduces

A model of income & wealth over the life cycle - problem with model?

• In reality income changes and may not be stable

Probability of getting a job at graduation?

• Bachelor have higher chances of employment (80%) than Year 10 (60%)

• So high education has higher employment rate (ABS, 2023)

Gender gap for jobs?

• Men have higher chance of employment than female

• Gender gap smaller for graduates

Chat GPT is more likely to replace jobs that are…

high wages, writing, programming, information processing, work that requires college degrees, minimal on the job training and routine/repetitive work

• Expected salary when you start work?

• Median starting salaries $71,000

• Growth rate is 4%

Marshmallow test (Mischel)

• to investigate the patient of children - gave them a marshmallow if you don’t eat it in 15 minutes they get 2 marshmallows

• The experiment studies people self-discpline and this is relevant to personal finance

Compounding

• Assuming a bank deposit earns 5% interest

  • Implies a compounding rate of 5%

What discounting rate or compounding rate to use?

• Inflation rate

• Government bond rate (risk-free rate)

• Fixed deposit rate

discounting

the opposite of compounding

Working out present values & future values - 3 questions

1. How big is the amount of money? (size)

2. How long before you receive it? (timing)

3. How much are you discounting it? (risk)