FHCE 3200 Module 1 Textbook Notes
FHCE 3200 Module 1 Textbook Notes FHCE 3200
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This 13 page Class Notes was uploaded by Morgan Notetaker on Sunday August 21, 2016. The Class Notes belongs to FHCE 3200 at University of Georgia taught by Matthew Goren in Fall 2016. Since its upload, it has received 11 views.
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Date Created: 08/21/16
FHCE 3200 Module 1 Intro Financial literacy: How well you understand and use personal finance-related info Concepts the financially literate understand… o How personal and economic factors impact a home’s financial situation o How to apply basic TVM concepts o How to develop a balance sheet o How to create budget and track income and expenses each month o How to do taxes o The costs and benefit of borrowing o How to choose among basic saving and investing choices o The importance of insurance o How to plan for emergencies o How to navigate the financial market place Characteristics of the financially literate: o Self control o Self confidence o Experience o Informed o Interested o Engaged o Express charity Pathway to wealth: o Keep good records, spend less than what is earned, have appropriate insurance, save money on regular basis o College education positively associated with being financially literate and wealthy Your View of the Financial World The key to financial literacy begins with understanding your “lens” of the financial world o Lens: how you view the world; perspective o Affected by how much risk you like Risk takers vs. Risk averse o Affected by how much control you think you have in life Luck and fate vs. In charge of life Ex. Some people think they can’t influence America’s large GDP (how much Americans produce in goods and services in a year) o This is a luck/ fate view o But majority of GDP is made up of consumer spending so you can control what products are made, their cost, future direction of economy o This is an “in control” view Half of the baby boomers worry they won’t have enough money to live comfortably during retirement o They tend to spend more than they earn o Falling birthrates and longer longevity means people need more money to live comfortably Financial Illiteracy: Stems from making financial and investment decisions that are too cautious The average American taking a financial literacy quiz will get a grade of C o Society expects people to already know how to save, where to invest, and do basic math o Learned from friends and family o Bad info can get passed down Financial Risk Tolerance Accumulation of wealth is tied to the willingness to take financial risk Financial risk tolerance: Willingness to engage in risky behavior that entails the possibility of loss o Risk tolerance lies on a scale and can change over time o Taking risks in life (e.g. skydiving) does not mean you’ll take financial risk o No one is born with high financial risk tolerance How to move up the risk tolerance scale: o Learn about financial topics gain confidence gain experience gain understanding move up in scale Those who think their future is determined by chance (i.e. fate and luck lens) typically make uninformed financial decisions o They make decisions based on hunches and whims Risk perception: how much risk you think there is o Just as important as reality o Person playing lottery perceives it as very low risk so they play a lot In reality, odds of winning are millions to one o Those unfamiliar with financial marketplace don’t understand it and may perceive it as very risky o Perception of risk has less to do with cognitive ability and more to do with media People perceive financial scandals (Madoff and ENRON) as being representative of financial markets Key takeaway: Don’t rely only on your perception of risk—do research Risk preference: Some prefer to take less risk than more and vice versa o Most want to be wealthier than poorer o You can’t get higher return without higher risk o Falls back to risk tolerance; how much risk are you willing to take What Are You Worth Human Capital: Your ability to work, learn, earn, and make wise decisions about how to save and invest money o Converted into retirement savings, investments, savings accounts, property, etc. o Increases with education, training, experience, continuing education, skill development o Increases with good health and closer physical location from employer Can’t work as much and may be forced to stop working if unhealthy o Earn more by locating to where your specific types of human capital are valued more Social Capital: How well you function with other people; o Found in network of connections among people o Informal Networks: Family and friends Help you get though hard times o Formal Networks: People you wouldn’t normally associate with Help with career advancement Investment Payback Period: How long it takes to earn back your investment o The longer it is, the more you should question the value of the investment Your Ability to Choose the Best Alternative Procrastination: The result of how you view the present moment relative to the future; You value the present more o Overly discount future rewards when comparing to present cost of the action Leads to undervaluing the future Behavioral Economics: How people make choices and why people make bad decisions o Heuristics: Mind’s shortcuts based on past experiences Applied to new situations that appear similar to past ones Often results in poor judgment and poor choices o Status Quo Bias: Preference for how things are People comfortable with current situation Changing seems too hard Fear of making wrong decision o Loss Aversion: Fear of losing money People much more upset by losses and focus on avoiding them Ex. Investors may focus on short term losses and not long term potential gains Potential gains need to be twice that of losses for people to be indifferent o Optimism Bias: People think they’ll never experience painful losses People think they’re above average in most daily activities Leads people to take more risky investments Confirmatory bias: Think something confirms they’re right even though it was a fluke o Having clear goals counters effects of heuristics Make Better Financial Decisions Pre-commit to decisions o Use deadlines, friends, family, colleagues to hold you accountable Automate good decisions o Automatically save money through employer or bank o Auto-pay bills Set clear goals o Define where you want to be financially and work towards it Companies use heuristics against you o They re-price contracts annually, costs rise, you don’t re- evaluate past decisions because of status quo bias o Credit cards offer teaser rates and special offers to new customers and raise rates later Time horizon and perspective Time can be viewed from a planning and a psychological perspective Planning Perspective o Put plan into action in terms of goal time horizon: Time between creating a goal and achieving it o Ultra-short (<9 months), Short-term (9 months- 2.5 years), Short-intermediate (2.5- 5 years), Long-intermediate (5-10 years), Long-term (>10 years) o Ultra-short and short-term time horizons: Make very cautious financial decisions Example: Investing in stocks is good for a 10+ years time horizon goal You have more time to make up any potential losses Time perspective: Very important element of time o People view the world with one of three perspectives (lenses) Past, Present, Future o Time orientation biases most things you do daily o Past Perspectives Make decisions based on past memories Either positive or negative memories o Present Perspectives Hedonistic orientation: You do things for the experience and excitement of the actions Fatalistic Orientation: You live in present because you can’t visualize a meaningful future o Future Orientations Very goal-oriented View the future in transcendental way (sacrifice things today for promise of life after death) These, especially goal-oriented, people are better at managing personal finance o Optimal combination: View past with fondness, live in present by seeking pleasure in activities, set goals and strive to meet them Marshmallow Test: Walter Mischel o Kids can eat one marshmallow now or eat two if they wait o 2/3 of the kids ate before lady got back o 60%-70% of Americans give in to temptation Impulsive and quick acting Present perspective o 15 years later, the same kids who didn’t eat the first marshmallow fared much better in life o Those with a future perspective got 150 points higher on SAT and were more content/ happier o Future discounting Will you take $1 today or $2 tomorrow? Will you take $100 in one year or $101 in a year and one day? Most people will not wait one day when faced with short term horizon (Take $1 and not $2) Most people will wait an extra day when time horizon is longer (Take $101 and not $100) The Rule of 72 Goals should be S.M.A.R.T. o Specific, Measurable, Attainable, Realistic, Timely Goal vs. Objective o Objective is a means by which goals are achieved o Ex. Goal is to buy new car in 3 years; Objective is to save $100 per month t FV= PV x (1+r) o FV= Future Value o PV= Present Value o r= Interest Rate o t= Required Time Horizon o Ex. You have $3,000 saved that’s earning 3% interest. How long will it be until you’re able to buy a $6,000 car? PV= 3000, FV= 6000, r= 3%, finding t FV= PV x (1+r) t t 6000= 3000 t (1.03) 6000/3000=1.03 2=1.03 t ln(2)/ln(1.03)=t=23.45 o Shortcut: Rule of 72 To find number of years needed to double your money, divide 72 by the interest rate: 27/r To estimate the interest rate needed to double your money, divide 72 by number of years: 72/t Ex. Look at previous example. 72/3= 24= 24 years needed to go from earning $3000 to $6000 Rule of 70 can be used when the interest rate is low (under 5%) Time Value of Money (TVM) PV= FV/ (1+r) t o Ex. You get $1000 today or $1200 in 5 years. The discount rate (rate of return you can earn on savings) is 5%. Compare the present value of $1200 to the present value of $1000. o PV of getting $1000 today is just $1000 o PV of getting $2500 in f5ve years is $940.22 PV= 1200/ 1.05 = 940.22 FV of annuity (FVA)= (pmt/r) x [(1+r) -1] o Annuity: Saving money on a regular basis; also called payments (pmt) o Payments happen more than once o Ex. How much will you accumulate in 20 years if you start saving $1000 every year and earn 9% on savings? Pmt= 1000, r= 9%, t=20 FVA= (pmt/r) x [(1+r) -1] 20 FVA= (1000/.09) x [(1.09) -1]= $51,160.12 How Money Works Interest: The price paid for the use of someone’s money o Putting money in a savings account is lending it to that institution o Bank agrees to pay you interest for its use of your money o Very low risk because can get your money back at any time Savings deposits are protected against loss by US gov’t (FDIC for banks and NCUA for credit unions) Low interest rates (lower risk= lower interest rate) Power of Compound Interest: The higher the interest earned, the greater your future wealth o Initial amount of interest earned grows slowly, but over longer periods of time it grows more quickly o The interest you earn is put back to work so you earn interest on your interest o Interest rates are reported in two forms Annual Percentage Rate (APR): The annual sum of the interest rates applied to the account; does not consider effect of compound growth APR= Periodic Interest Rate x Number of Periods in the Year Ex. Bank pays you .2% interest monthly. APR= .2% x 12 months= 2.4%. Annual Percentage Yield (APY): The annual sum of interest applied to the account; accounts for compound growth number of periods in year APY= [(1+ periodic interest rate) ] -1 Ex. Bank pays you .2% interest monthly 12 APY= [(1+.002 ]-1= .0268=2.68% Number of periods is 12 because there are 12 months in a year APY > APR as long as there is more than one compounding period in a year Use APY when comparing savings options and loans Use APY as “r” in the Rule of 72 o Restricted access to accounts may help you save over time Absolute restrictions, penalties, or behavioral restrictions Ex. US Savings Bonds can’t be redeemed for at least one year following their purchase (absolute restriction) Ex. Some accounts charge penalties if money is withdrawn before maturity date Ex. Behavioral restrictions include making it harder to access or more mentally painful to spend Save money in a bank far away from your house and with no electronic access Name account “New Car” so as to feel guilty when you take money out of it Developing Financial Goals Long-term Goals: A big picture idea of where you want to be financially Short-term Goals and daily tasks: Immediate actions taken to reach longer term goals The clearer you picture your ideal future financial state, the more action you can take to achieve it Locke’s Goal Theory: The more challenging a goal is, the higher your performance will be o If something is difficult, you will need to give it your full attention and effort o Important to make sure you have the skills to achieve the goal Won’t achieve it if you don’t have the knowledge or skill to get there Maintaining Commitment to Goals Commitment and motivation largely depend on how important goal is to you External Factors: Share goals with others or tie to financial reward Internal Factors: Personal reasons for reaching a goal o Both factors require you to visualize your goal o Clearly identify a future that is important to you o Self-Efficacy: How well you believe you can do something Must believe you can achieve goal A in SMART stands for attainable Balance Sheet Use Balance Sheet to help organize assets (what you own) and debts/liabilities (what you owe) Net worth= Assets – Liabilities Left side lists everything you own (assets) o Add if you can legally sell the asset o Includes monetary assets, investments, retirement accounts, insurance, real estate, cars, collectibles, personal items, lifestyle items o Must be listed at fair market value: The price someone would realistically pay you to buy the asset Not the price you did or would pay for it Check for price that it was just sold for-- not the ask price Check pawn shops, thrift stores, flea markets, yard sales Get an appraisal Right side lists what you owe (debt or liabilities) o Important: You can own something and still owe money on it o Ex. Car costs $14,000 (asset). You borrowed $10,000 to help pay for it (debt or liability). The Net Worth= Asset- Liability= 14,000 – 10,000= $4,000. o Includes credit card debt and loans that haven’t been paid Most liquid assets are on top of the list on the balance sheet; least are on bottom o Liquidity: How quickly you can convert an asset to cash Liabilities are listed based on when debt must be paid off o Short-term debt: Due within one year; Includes utility bills, credit cards, installment loans o Intermediate-term debt: Includes car loans o Long-term debt: Includes student loans, mortgages, etc. Lenders (banks, credit unions, loan providers, etc.) want to know your net worth before giving you a loan or credit card o Higher net worth better deals on loans o Normal for high school and college student to have negative net worth o Expect negative net worth at beginning of financial journey o Good debt: Investments in human capital such as education, transportation, other items needed to earn money today and in the future o Bad debt: Borrowed money to buy something that goes down in value quickly or is consumed immediately o Financial Ratio: Formula telling you how well you’re progressing financially Current Ratio: Monetary Assets Goal is to be Short−termDebts above 1.0 Total Liabilities Debt Ratio: Total Assets Goal is to be greater than 40% Managing Your Resources Set and know your financial goals o Make S.M.A.R.T. goals o Realize how financial decisions affect you, your relationships, your feelings Track where your resources come from and how they’re currently used o Tracking your income and expenses: Track what you purchased and amount you spent Helpful site for this: Mint.com Develop your own set of guidelines regarding use of resources o Budget: Financial tool used to regulate how quickly and in what ways your money is used o Budgets have income, savings, and expenses sections o Frequently compare your tracked income/ expenses to your budget You want a surplus: money left over that you can put toward goals Don’t want deficit: when you spend more than your income
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