CommonSenseEconomics.com

Twelve Key Elements of Twelve Key Elements of Practical Personal Practical Personal

FinanceFinance

Common Sense Economics

James Gwartney, Richard L. Stroup, and Dwight R. Lee

CommonSenseEconomics.com

A Personal Financial Epidemic?

• Why do Americans live under so much financial stress when their incomes are higher than ever?

• Financial insecurity is the result of the choices we make rather than the income we earn.

• The principles that lead to financial security are largely the same as the ones underlying a prosperous economy.

Practical Element #1

Discover your comparative advantage.

Comparative Advantage

• We are all relatively more productive in some areas than in others.

• Your comparative advantage is determined by your comparative abilities, not your absolute abilities.

What’s Your Comparative Advantage?

• Even if you’re better at doing everything, you shouldn’t do everything.

• Specialize in what you are relatively the best at.

Practical Element #2

Consider being entrepreneurial.

In a market economy, people get ahead by helping others and discovering better ways

of doing things.

Who are Who are Entrepreneurs?Entrepreneurs?

• People adept at discovering better ways of doing things and acting on these opportunities.

• Disproportionately wealthy… 2/3 of American millionaires are entrepreneurs.

Entrepreneurs’ Success:

1. Entrepreneurial talent: the ability to discover innovative new products, cost-reducing production methods, and profitable opportunities that have been overlooked by others.

2. Tolerance for risk: Self-employment is more risky, but greater risk and higher returns go together.

Is being an entrepreneur for you?

Entrepreneurs’ Success (cont.)

3. High Savings RatesKeep in mind

4. Hard Work …Business owners tend to work longer hours.

Practical Element #3

Spend less than you earn.

Begin a regular savings program now.

Why Save?• Saving is necessary to

accumulate the capital needed to produce wealth.

• This is just as true for individuals as for nations.

• The most effective way to begin saving is by identifying and eliminating some discretionary spending.

Don’t Wait!!!Don’t Wait!!!

• If you don’t exert the willpower to save now, it is unlikely that you will do so later.

• If you wait to save until your income goes up, it is extremely costly in terms of the amount of money you will end up with at retirement.

There’s No Need to Suffer!

There are MANY creative ways to spend less.Ø Pay yourself first! Make saving a regular expense.Ø “Just do it!”

Practical Element #4

Don’t finance anything for

longer than its useful life.

Financing Consumption

• Why continue to pay for something- a car, a vacation, a television- that you are no longer able to use and enjoy?

• Purchase on credit only when buying a long-lasting asset with short-lasting financing.

When should you buy on credit?

What goods and services can you pay for while you use them?– homes– automobiles (depending on lifespan)– education

Some assets even generate income or further service even after you finish paying for them…these can enhance your net worth!!!

Practical Element #5

Two ways to get more out of your money:

Avoid credit card debt and consider

purchasing used items.

Don’t Undermine Your Future!!!

• The opportunity cost of saving for tomorrow is spending (and enjoying!) today.

• You CAN have more in the future while still enjoying today…

“…ordinary people can have lots of nice things and still accumulate a lot of money.”

Credit Card Convenience

• Paying with a credit card is NOT spending your own money, but borrowing someone else’s.

• Interest charged on credit cards outstrips returns that could be earned on investments!!!

• Think of your credit card as an extension of your checking account…Use your credit card only to access those funds.

The World’s Most Expensive Vacation

• Sean charges $1,500 for a trip to the Bahamas.

• He pays the minimum payment ($26.63 at 8% interest) each month.

• 10 YEARS LATER this trip has cost Sean $3,195.40, and all he has left are faded photos.

It Pays to Buy Used!

• Can a used item satisfy you as well as a new item?

• Balance the time it takes to search for these items with the value of your time.

lThere are savings to be had without having to sacrifice consumer satisfaction!

Practical Element #6

Begin paying into a “real-world” savings account

every month.

Rainy Days & the Real World

• Life is full of surprises, and they’re usually expensive!

• The surprise is only in the timing…So it IS possible to plan for these surprises!

• Purchase “peace of mind” by building a cushion…Make this a regular and mandatory expense!

Practical Element #7

Put the power of compound interest

to work for you.

It’s a Miracle!!!It’s a Miracle!!!• Getting a head start

brings a HUGE payoff.

• Compounding occurs when the interest you’ve already earned earns even more interest on itself.

Practical Element #8

Diversify- don’t put all of your

eggs in one basket.

Risk vs. ReturnRisk vs. Return

• There is no such thing as a guaranteed return!

• Diversification is the practice of holding a large number of unrelated assets.

– Stocks– Bonds – Cash– Property

Double Jeopardy (Things to consider when you work for a large company)• Does your employer offer a company stock-

based retirement program?• IF you have confidence in the company, take

advantage of the opportunity.• As soon as the plan permits, sell these shares

to purchase other investments.• Failure to do so puts you in double jeopardy

…You are now beholden to your employer both for your job and your retirement investment. You are NOT diversified!!!

Practical Element #9

Considering buying mutual funds?

Indexed equity funds can help you beat the experts without taking excessive risk.

The Random Walk Theory

• No one can predict the future of the stock market.

• The random walk theory suggests that current stock prices are the best reflection of the market’s value.

• The future price of a stock is driven by unforeseeable events.

• Since we can only see the present, it is impossible to “beat the market”.

Practical Element #10

Invest in stocks for long-run objectives;

as the need for money approaches, increase

the proportion of bonds.

So Why Not Just Hold Bonds?

• Bonds offer a lower return than stocks, but with less risk.

• Inflation risk and interest rate risk are larger problems with bonds.

• Buy bonds that mature at the time you anticipate needing the cash.

• Transfer capital gradually from stocks to bonds.

Practical Element #11

Beware of investment schemes promising

high returns with little or no risk.

There’s no such thing as a free lunch!!!

• If it’s such a good deal, why do they need to sell it to you???

• The principal-agent problem makes you vulnerable.– A potential conflict exists

between the investor and the agent being paid to do something for the investor…Because the agent has more information about the product than you, you are at a disadvantage.

Practical Element #12

Teach your children how to earn money and

spend it wisely.

Teach Your Children Well

• Teach children money is earned …It doesn’t grow on trees!

• Money both helps us get what we want, AND helps others get what they want.

• Success in general is realized by setting goals and working hard to achieve them…Financial success is no different!