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Personal Finance
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Personal finance is the process of planning and managing personal financial activities such as income generation, spending, saving, investing, and protection. The process of managing one’s finances can be summarized in a budget or financial plan.
Each of these areas will be examined in more detail:
Personal Finance Budget
Preparing a budget or a financial plan is critical for giving you the best shot at achieving your personal and family goals.
As you can see in the example below, there are three potential sources of income (salary, bonus, and other), followed by a list of expenses (rent, food, groceries, restaurants, entertainment, childcare costs, vacations, etc.), and the difference between the two is the person’s monthly surplus or deficit.
Personal finance is the process of planning and managing personal financial activities such as income generation, spending, saving, investing, and protection. The process of managing one’s finances can be summarized in a budget or financial plan. We will analyze the most common and important aspects of individual financial management.
As shown below, the main areas of personal finance are income, spending, saving, investing, and protection. Each of these areas will be examined in more detail below.
#1 Income
Income refers to a source of cash inflow that an individual receives and then uses to support themselves and their family. It is the starting point for our financial planning process.
Common sources of income are:
- Salaries
- Bonuses
- Hourly wages
- Pensions
- Dividends
These sources of income all generate cash that an individual can use to either spend, save, or invest. In this sense, income can be thought of as the first step in our personal finance roadmap.
#2 Spending
Spending includes all types of expenses an individual incurs related to buying goods and services or anything consumable (i.e., not an investment). All spending falls into two categories: cash (paid for with cash on hand) and credit (paid for by borrowing the money). The majority of most people’s income is allocated to spending.
Common sources of spending are:
- Rent
- Mortgage payments
- Taxes
- Food
- Entertainment
- Travel
- Credit card payments
The expenses listed above all reduce the amount of cash an individual has available for saving and investing. If expenses are greater than income, the individual has a deficit. Managing expenses is just as important as generating income, and typically people have more control over their discretionary expenses than their income. Good spending habits are critical for good personal finance management.
#3 Saving
Saving refers to excess cash that is retained for future investing or spending. If there is a surplus between what a person earns as income and what they spend, the difference can be directed towards savings or investments. Managing savings is a critical area of personal finance.
Common forms of savings include:
- Physical cash
- Savings bank account
- Checking bank account
- Money market securities
Most people keep at least some savings to manage their cash flow and the short-term difference between their income and expenses. Having too many savings, however, can be viewed as a bad thing since it earns little to no return compared to investments.
#4 Investing
Investing relates to the purchase of assets that are expected to generate a rate of return, with the hope that over time the individual will receive back more money than they originally invested. Investing carries risk, and not all assets actually end up producing a positive rate of return. This is where we see the relationship between risk and return.
Common forms of investing include:
- Stocks
- Bonds
- Mutual funds
- Real estate
- Private companies
- Commodities
- Art
Investing is the most complicated area of personal finance and is one of the areas where people get the most professional advice. There are vast differences in risk and reward between different investments, and most people seek help with this area of their financial plan.
#5 Protection
Personal protection refers to a wide range of products that can be used to guard against unforeseen and adverse events.
Common protection products include:
- Life insurance
- Health insurance
- Estate planning
This is another area of personal finance where people typically seek professional advice and which can become quite complicated. There is a whole series of analyses that needs to be done to properly assess an individual’s insurance and estate planning needs.
The Personal Finance Planning Process
Good financial management comes down to having a solid plan and sticking to it. All of the above areas of personal finance can be wrapped into a budget or a formal financial plan.
These plans are commonly prepared by personal bankers and investment advisors who work with their clients to understand their needs and goals and develop an appropriate course of action.
Generally speaking, the main components of the financial planning process are:
- Assessment
- Goals
- Plan development
- Execution
- Monitoring en reassessment