Fundamentals of Personal Finance: Part II

Hello, friends. Our study of personal finance fundamentals continues. We are making use of an analogy with the London public transit system. Part I of this three-part series was about Understanding the Map, and covered the fundamentals of finance. This part is entitled:

Planning your Trip: Making Goals and Choosing Investments

Take a look at your starting point on the map first.

dsc01287Back in London, I needed to know where my hotel was in relation to Abbey Road in order to choose the right stations and rail lines. This is much like financial planning. Evaluating your current position is essential in setting goals. To do this, answer some questions about your finances and other factors:

  • How old are you?
  • How many more years do you expect to be earning money?
  • How old do you think you will be when you retire from your job if you choose to retire?
  • How much money do you earn? (Weekly? Monthly? Annually?)
  • What expenses are necessary? (Weekly? Monthly? Annually?)
  • What expenses are optional? (Weekly? Monthly? Annually?)
  • How much money can you save? (Weekly? Monthly? Annually?)
  • How much money can you give? (Weekly? Monthly? Annually?)
  • How much money do you need to pay off your loans? (Weekly? Monthly? Annually?)
  • How much money do you have in your savings accounts?
  • How much money do you have in your retirement accounts?

 Next, locate your destination on the map.

Choosing a destination on the map is much like formulating goals. What are your plans for the future? After you evaluate your starting point, answer some questions about your destination:

What are your goals for…?

  • Housing? (Do you want to buy a house? Do you want to move to another state?)
  • Education and career development? (Do you want to pursue a professional certification?)
  • Transportation? (Do you need a new car? Are you paying off a car loan?)
  • Giving? (Do you want to sponsor a child? Do you want to support a missionary?)
  • Family? (Are you planning a wedding? Do you have to pay tuition for your children?)
  • Retirement? (What might you do when you are too old to work?)
  • Emergencies? (Do you have money set aside for unexpected health problems?)
  • Travel or recreation? (Do you want to travel to London and see Abbey Road?)
  • Big purchases? (Do you need a sewing machine or new windows on your house?)

Categorize and prioritize your goals. How many years do you need to reach each goal? Are the short-term or long-term? Which goals are vital? Which are optional? Estimate how much money each goal requires.

Now that you have outlined where you are and where you want to go, it is time to figure out how to get there. Now that you have begun to explore your goals and how much money is needed to reach them, you can look at ways to accumulate that money. A good first step is to make a plan to save cash regularly. A good second step is to invest some of that cash in commodities, stocks, bonds, and other investments, assembling a portfolio. (Remember, a portfolio is an allocation of cash, commodities, stocks, bonds and other investments).

Choosing a rail line represents putting together a portfolio.

All kinds of rail lines straddle London. Some are long and some are short. Some have many stations and some have few. The effects of these differences are not merely geographical. The lines with greater distances between stations allow for travel at much higher speeds. For example, trains on the Victoria and the Metropolitan lines can reach 50 miles per hour and 60 miles per hour, respectively, rates much greater than the average 30 miles per hour. While we presume this mode of transportation is safe, you can imagine that a train traveling at 60 miles per hour would probably get in a much worse accident than a train traveling at 20 miles per hour. At higher speeds, you can get to your destination more quickly, but you are at a greater risk if the trail is derailed. These variations are a good representation of the relationship between growth potential and risk of different investments.

While this post is not designed to cover all the intricacies of investing, it will introduce you to basic concepts. Everything will be discussed in general terms.

Stocks have a greater potential return on investment than other investments.

dsc01514Stocks have higher “rail speeds”; they can earn more over time compared to other investments. At the same time though, there is a greater risk that the value of stocks will decline in the short-term. With these characteristics, stocks are useful in earning money over the long term. Stocks thrive when the market is doing well.

On the other hand, bonds have lower risk. The earnings on bonds have a lower potential return on investment, but they are guaranteed. Bonds have slower “rail speeds”; they can earn less over time compared to other investments. With these characteristics, bonds are useful in preserving money. If you need to make sure you do not lose money in your investments and have only a short time to recover from market downturns, bonds are a good choice. Bonds thrive when the market is not doing well.

Usually, portfolios have various combinations of stocks and bonds along with other investments. The composition of a portfolio reflects its goal. A portfolio with mostly stocks is growth-oriented and has a long time horizon to weather the ups and downs of the market. The more time you have to reach your goals and recover from market downturns, the more risk you can afford to take.

A portfolio with mostly bonds is designed to preserve the value of the account; it is not growth-oriented. It reflects a goal that has a short time horizon. The less time you have to reach your goals, the less risk you can afford to take. In this case, it is wiser to invest more heavily in bonds because you have less time to recover from any market setbacks.

Anticipating train breakdowns or delays represents preparing for downturns in the market.

When you plan a train trip, it is wise to be prepared for unexpected problems.   A loose bolt might be making its final orbit around its screw, sending a car careening off the tracks, or a passenger’s enthusiasm might be insufficient in compensating for his foolishness as he leaps off the ledge. In a moment, a timetable goes awry. Therefore, allowing for more time to travel can help you reach your destination on time and to find alternate routes if necessary. Likewise, the longer you have to save and invest money, the greater potential return on investment you have.

Part three of this series will help you to help you to maximize this time and get started as soon as possible.

20100503rachel-portrait-106Author Bio: Rachel is a Christian and serves her church. She enjoys thinking of puns during long trail runs. If she had to choose between cheese and chocolate, she wonders what she couldn’t live without.

 

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