A Practical Guide to Personal Finance E-Book

Michael Taillard

• Herausgeber: Icon Books
• Kategorie: Ratgeber
• Sprache: Englisch

Seitenzahl: 229

Veröffentlichungsjahr: 2015

Beschreibung

MAKE YOUR MONEY WORK FOR YOU by matching your spending and investments to your values CONTROL YOUR SPENDING BEHAVIOUR by gathering and tracking financial information efficiently SIMPLIFY YOUR FINANCIAL MANAGEMENT by learning to use the right tools effectively REALIZE YOUR SAVINGS GOALS by understanding what you want to and can achieve Introducing Personal Finance, by economics expert Michael Taillard, teaches you everything you need to know about managing your financial life. It's crammed full of practical advice on how to save, earn and get the most out of your money.  

Leseprobe

Published in the UK and USAin 2015 by Icon Books Ltd,Omnibus Business Centre,39–41 North Road,London N7 9DPemail: [email protected]

Sold in the UK, Europe and Asiaby Faber & Faber Ltd,Bloomsbury House,74–77 Great Russell Street,London WC1B 3DAor their agents

Distributed in South Africaby Jonathan Ball,Office B4, The District,41 Sir Lowry Road,Woodstock 7925

Distributed in Australia andNew Zealandby Allen & Unwin Pty Ltd,PO Box 8500,83 Alexander Street,Crows Nest,NSW 2065

Distributed in Canadaby Publishers Group Canada,76 Stafford Street, Unit 300Toronto, Ontario M6J 2S1

Distributed to the trade in the USAby Consortium Book Salesand DistributionThe Keg House,34 Thirteenth Avenue NE,Suite 101,Minneapolis, MN 55413-1007

ISBN: 978-184831-723-9

Text copyright © 2015 Michael Taillard

The author has asserted his moral rights.

No part of this book may be reproduced in any form, or by any means, without prior permission in writing from the publisher.

Typeset in Avenir by Marie Doherty

Printed and bound in the UK by Clays Ltd, St Ives plc

To those who work yet struggle.

To those who struggle to work.

To those who invent, or write, or dream without financing.

To those investors and entrepreneurs without funding.

You are the unsung heroes of innovation – the discontented geniuses too often left without witness.

Find here tools to thrive in a world which prevents you from achieving your potential yet punishes lack of success.

About the author

Michael Taillard is an economic consultant specializing in behavioural research and financial strategy. Besides authoring a variety of books on economics, finance, and strategy, his writings have been featured in major international news outlets. He has taught graduate-level courses at a variety of universities in the US and China, and is currently involved in the MBA programme at Bellevue University in the US. He has assisted major organizations from around the world in their development of strategic resource management, including the US Department of Defense, the American Red Cross, Ocean Audit, Inc. in the Czech Republic and Saving Humanity in Australia.

Contents

1.   Getting started

2.   Budgeting

3.   Banking

4.   Major purchases

5.   Debt management

6.   Investing

7.   Risk management

8.   Income

9.   Retirement planning

10. Behavioural finance

Conclusion

Glossary

Templates

Index

1. Getting started

There are a number of different philosophies on finance, some stating that money is ‘the root of all evil’ or that money is a valueless fraud, which has tricked the world into pursuing its own demise. Other, less depressing views on finance see money as a medium of exchange, or as value itself. Most people don’t even care what the underlying nature of money is, so long as they continue to have enough of it to pay their expenses, but the nature of money is a representation of human nature, the way we coordinate societies. Unless you understand the nature of money and finance, you cannot possibly hope to effectively manage either. So, before explaining how to manage your finances, we must first explain exactly what you will be managing, as well as how to begin.

What is finance?

Money is debt. Surely it’s rare that a person will provide their services to customers or employers for free, but if the recipient of those services has nothing you want in return at the moment, then the exchange becomes more difficult. They could offer you a credit for their own goods or services, but there are times where a barter transaction like this simply will not work, either because one person has nothing the other wants or the timing is wrong. Instead, they give you a credit which you can give to anyone else, which will still be honoured regardless of who has it. This trait is called transferability, and it’s what allows money to be given to others in exchange for their services, and after several intervals of exchange; eventually, it will likely be given back to the person who originally gave it to you, by whomever needs his services. Money, then, is nothing more than a form of measurement, providing a numerical way to record the amount of value in goods or services that are owed and can be transferred freely between people, which is exactly how money gets its value.

Transferability: A characteristic (of a credit) of being able to readily transfer or exchange ownership.

Money: Any store of resource value owed to the owner.

Money, by itself, has almost no value at all. Philosopher of the Scottish Enlightenment, Adam Smith, saw this as the paradox of value, wherein water is crucially useful yet people place so much more value on gold. This seeming paradox is resolved exactly for that reason; however – because water is so useful and is used in such huge quantities – it is difficult to maintain as a unit of measurement, since it has a tendency to be consumed, expire or otherwise become difficult to transport. That’s not to say that these types of currencies don’t exist, since spices, silks and especially salt have all been used to great success as types of hard currencies by merchants, traders and entire civilizations – even cigarettes are effective as a currency in prisons – but they still hold the same challenges as attempting to use water as a currency. By contrast, gold has almost no intrinsic usefulness, which is exactly why it works well as a way to measure value. The gold itself has little value, but the underlying resources which it represents are those upon which we place value. Since it is rare, light and lasts indefinitely, it is simple to carry small quantities of gold that will be sufficient to partake in even large transactions.

Whether we are talking about gold, silver or copper coins, paper or digital cryptocurrencies, like Bitcoins (or any other transferable unit of value measurement), it is all fiat currency. Fiat currency is any currency whose value is derived from people’s willingness to use it. The simple fact that you are willing to provide services to your employer in exchange for a currency is what gives that currency its value. Whether that money has any functional purpose on its own is irrelevant, so long as you can achieve those functional purposes by giving the currency away to others. Nearly every exchange transfers value in two directions: someone provides goods or services of useful value, and in exchange they are given by someone else a measure of value owed to them which they can then exchange for something else of useful value.

Every single exchange establishes not just the money-value of the goods and services, but also the resource value of the money. When you buy something, you have voted and said that you agree the resources you are receiving have value equal to or greater than whatever you did to earn the money, which is the core of finance.

Fiat currency: Any currency which derives its value from the value of the resource exchanges it represents.

Whereas money is the unit we use to measure a debt of resource value, finance – which studies the way in which money is used – becomes a study of human behaviour. Finance gives us a profound look into the human mind as we come to understand the value people place on specific types of goods and services, on their own time, on the potential to earn more money or on the amount of risk inherent in every financial decision we make. Each time you buy or sell something, two people have voted to agree that the value of the exchange was comparable, with each party earning more value in the exchange than they would have by keeping the resources or money they already owned. By contrast, by refusing to buy or sell at a given price, you have voted to say that the value is not comparable, though others might disagree – even if you do not buy or sell the thing in question at a given price, someone else may be willing to accommodate that price. We can look deep into the priorities and values that an entire society holds by looking at prices, as higher prices indicate that people place greater value on something, while lower prices indicate that people, on average, place lower value on something. All the needs, and desires, and hopes, and dreams, and comforts, and resentments, and jealousies which exist within an entire culture, then, can be understood in terms of price, money, and exchange – such is finance.

When doing anything related to financial management, you are actually managing your values. All the work you have ever done, everything you will ever own, your quality of life, your hopes for the future, your tastes and opinions, and even your personality are all encompassed in your personal finances. Each financial decision you make is an expression of your life and your mind, so much so that a person’s financial well-being plays a critical role in their emotional state, as several studies have shown rich people truly are happier and more confident, while those who struggle financially suffer the stress and hardship that comes with uncertainty and loss, and trouble with money is the most commonly reported cause for divorce. Financial management actually has very little to do with money – money is just a unit of measurement – financial management is about taking control of your life.

Collecting financial information

You can’t make decisions about your finances until you have some information with which to work, otherwise you are simply guessing. A common beginner’s error is to simply keep a written record of all money earned and spent. While this is elegant in its simplicity and seems reasonable if people were completely rational, the truth is that people are not completely rational. Besides being extremely time-consuming and tedious, making people prone to give up, when you pay extra attention to your spending behaviours, those behaviours fundamentally change. In a psychological anomaly known as the ‘observation effect’, discussed in more detail in chapter 10, when people pay extra close attention to their spending behaviours, they also tend to be more careful with their spending – they will take the extra time to consider how important a purchase really is to them, which fundamentally improves their finances. Since improving your finances starts with understanding what your normal financial behaviour is like, you are going to need to use some other method of getting that information.

Lagging indicators, which is information collected in hindsight, allow you to assess your financial behaviour over some period of time in the recent past. Keeping your receipts has been a very popular method since even before money was commonly used; it is very effective but also very time-consuming, and receipts are easily lost or damaged. With the invention of both credit and debit cards came the bank statement, which can include your transaction history when requested – a list of your earnings and spending with labels reasonably accurate enough to trace the types and locations of transactions. Though debit cards work the same as normal money in most ways, credit cards accrue interest, which means you have to pay back more than you spent. So, if you plan to use credit cards to track your spending, always make sure to pay back the balance before the interest accrual date (another thing people tend to get lazy about, resulting in higher costs than the value of your purchases). Internet banking has been another boon for tracking financial behaviour, since everything you do can be recorded and referenced easily from any location with internet access.

When recording or evaluating your financial records, it’s also important to recognize that every transaction is two-way. In a simple example, imagine you are transferring money from your bank account to your investment account – even though the value of your investments has increased as a result, the value of your bank account has decreased. The wages you earn from you work will increase the value of your bank account, but decrease the value of wages still owed to you (sometimes called ‘wages receivable’). While this process of financial record keeping, known as ‘double-entry accounting’, will be explained in more detail in chapter 3, for now just remember that every financial action has an equal and opposite reaction, and that when you are recording or evaluating your records, every change will correspond to a different, opposite change.

Lagging indicators: Measurements of past events that allow you to assess financial behaviour over a period of time.

Scheduling

The frequency with which you address individual elements of your finances will vary from person to person, but there are some general guidelines. If you don’t revisit your finances frequently enough, then you will miss opportunities and increase waste, but if you revisit them too often, you will become hyperaware of every minor fluctuation, thereby increasing your propensity to erroneously respond to unimportant information and to stress yourself to the brink of madness. For example, unless you are an active day-trader, if you check your stocks every single day, you are likely to perceive patterns or movements which simply don’t exist. Our minds are engineered to seek trends and patterns, which is why we see faces in objects like the moon or carpeting. This pattern-seeking behaviour can also cause us to respond to financial information that is completely meaningless to everyone except the most active of securities traders, who now use computer algorithms anyway, making the minutely stock update a mere re-enactment of now ancient finance.

Each person should be checking their finances as frequently as they need to be responsive. For example, if your income and spending stay very consistent every month, you keep your bills on auto-draft and you have a bit of extra money in the bank in case of emergencies, then you don’t need to manage your banking or bills as carefully. By contrast, if you are just barely paying your bills, get paid at the end of each day and have inconsistent spending, then you will need to pay much closer attention. The former person, with steady finances, would likely be safe reviewing their accounts on a monthly or even quarterly basis, while the person with greater financial volatility should probably check their status once or twice per week. If you are managing investment accounts, then how often you revisit your investments depends not only on your investing strategy, but also the type of account you are managing (i.e. brokerage vs retirement, managed vs unmanaged, etc. – all discussed throughout several chapters of this book). In order to know how frequently to check each aspect of your financial management, first ask how frequently each aspect is going to deviate from your expectations. This book will help you answer that question.

Integration

The final point to make before we get started with actual financial management is that everything is easier when it’s integrated. Financial management uses a lot of data, a lot of calculations and a lot of reports, and they all connect together like pieces of a puzzle. Managing your finances is so much quicker and easier when the data from one report is automatically inserted into all the other reports that rely on that piece of data. In Charles Dickens’ A Christmas Carol, Bob Cratchit is an old-fashioned bookkeeper, doomed to flip through countless accounts and ledgers to reference and copy the same information over and over – a Sisyphus of the age of merchants and bankers. Now that we have computers, even the simplest spreadsheet or database software can turn weeks’ worth of work into a single day’s job. Each chapter of this book contains unique information and can be read on its own; however, each contributes useful information to decisions that can be made in every aspect of your finances, such that you will get the most out of your reading by working through the whole book. By automating the overlap using programs from Microsoft Office or Intuit, and programming languages like SAS and SQL, not only does basic financial management become much simpler, but customized financial tools can be developed that push the cutting edge of what’s possible and allow your average person to compete with major hedge funds, in their own way.

2. Budgeting

People tend to have the wrong idea about what budgeting is supposed to be. For most, a budget is merely a way to keep track of their spending, intended to help them from spending more than they earn, a goal in which they far too frequently fail. This view of budgeting leaves people financially stagnant, simply working to pay their bills, willing to overpay for expensive items through debt simply because they have some extra money with which they have no plans. This fundamentally flawed view of budgeting as a list of expenditures not only causes people to be wasteful with their money, but also to miss vital opportunities with which they can improve their income and optimize the value of their assets.

What most people think of as a budget is actually closer to a simplified form of a personal income statement: a report that tracks income and expenditures.

The goal of creating a quality budget, by contrast, is to manage the allocation of assets – a planning tool used to collect information and make decisions regarding the manner in which you use the resources available to you. Rather than being focused on setting limitations to your expenditures, a well-made budget will provide detailed information about how you distribute your resources and how you can optimize your finances in the future.

Budget: A periodic estimation of resource volume and distribution.

Personal income statement: A report of a person’s or household’s income, expenditures and financial gains and losses.

Personal income statement

An income statement is a simple list of the money you make and the money you spend. It’s a tool intended to help identify whether you are earning or losing money and the causes of these outcomes, and to track changes in them over time. While many people inappropriately try to use their budget to accomplish these goals, it’s actually the income statement which is used to determine how much money you are earning and spending. The income statement is arranged as follows:

Net sales – This is the total amount of income you earn from your primary employment (not including one-time earnings like inheritances or winnings) before you pay taxes, your bills or anything else. If you have multiple sources of income, make sure to distinguish them and list the amount earned from each source, in addition to the sum total from all sources.

COGS – The cost of goods sold (COGS) is a standard consideration on company income statements but all too frequently gets ignored on personal income statements, despite its critical importance. COGS is the total amount you spend in order to earn your income, including the cost of commuting, uniforms or professional clothing, networking and other professional social engagements, and so forth. Any money which you spend exclusively for the purpose of earning your wages should be included. Some people prefer to list this as a single, aggregate cost rather than listing each cost component individually, but it’s recommended that you include each component in addition to the total – not only is it more informative in managing your costs, but it’s also beneficial when filing your taxes.

Gross margin – The gross margin is calculated easily by starting with your total net sales and then subtracting your total COGS. This is an extremely important value because it tells you what your true take-home pay is for the period. Depending on where you live, this is also likely to be the same value as your taxable income, since many administrations allow tax deductions on business expenses.

Operational expenses – This includes all the other money you spend. Anything you feel you need to spend in order to sustain your daily life is considered an operational expense. Any money you spend on food, clothing not exclusive to work, entertainment, insurance and everything else is included here. Given the potentially broad nature of the types of expenses which can be included here, it’s usually prudent to lump similar items together. Rather than listing your beer purchases for the month, for example, you might include it as an ‘entertainment’ cost.

One-time earnings/losses – This includes any money you earn or spend which is a one-off, in other words, any income or expenses which are not typical for you. This value can be positive or negative, depending on what’s happened to you during the period. Costs associated with natural disasters or medical conditions can be included here, as can inheritances and gambling winnings/losses.

EBIT – Your earnings before interest and taxes (EBIT) are easily calculated: start with your gross margin, subtract your total operational expenses and then factor in your one-time earnings or losses (by adding or subtracting, respectively). This is all the money you have which you haven’t spent and don’t plan to spend in the immediate future.

Taxes and interest – If you pay taxes or interest on debt, then include everything you pay for either of these in the period here. This is an important category on the income statement because it gives you information about the costs associated with funding your earnings and expenses using debt or government services – a concept which will be discussed in greater detail in chapter 5.

Net income – This is the last item on your income statement. Start with your EBIT, then subtract your taxes and interest payments. This is the amount of money that you will put into investments or savings. This value is absolutely critical to watch for trends and to carefully manage because this is the amount by which your total wealth either increases or decreases for the period.

It seems like a lot to remember, but as long as you keep track of your financial information, the hardest part is just remembering where to include each item. In the end, your income statement should look something like this:

Net Sales Source 1

£XX.xx

Net Sales Source 2

£XX.xx

     Total Net Income

£XX.xx

COGS Source 1

£XX.xx

COGS Source 2

£XX.xx

COGS Source 3

£XX.xx

     Total COGS

£XX.xx

Gross Margin

£XX.xx

Operational Expense 1

£XX.xx

Operational Expense 2

£XX.xx

Operational Expense 3

£XX.xx

     Total Operational Expenses

£XX.xx

One-Time Earnings/Losses

£XX.xx

EBIT

£XX.xx

Tax and Interest Payments

£XX.xx

Net Income

£XX.xx

If you put each period’s income statements next to each other, it’s possible to do what is called a horizontal analysis – an assessment of changes in each item. By calculating the percentage of change between periods for each item, you can track trends, which may indicate a change in your costs or revenues, and can identify the sources of that change. Horizontal analyses are great for tracking changes over time and are often described in terms of YOY (year over year), QOQ (quarter over quarter) or MOM (month over month). By contrast, a vertical analysis includes any calculations of ratios between two or more elements in a single financial statement. For example, in an income statement, you might want to calculate the percentage of your total income spent on operational expenses or, even more specifically, your mortgage. Whereas horizontal analyses track changes over time, vertical analyses assess the composition of your finances. Despite the fancy names, there’s really nothing complicated about them – they are just calculations of percentages, performed by dividing one value by another, just like you learned at primary school.

Horizontal analysis: An assessment that calculates financial changes over time.

Vertical analysis: An assessment that calculates the composition of financial allocations.

Budget

The reason it’s necessary to understand the income statement before we discuss budgeting is that your budget will include information from your income statement. Recall from earlier in this chapter that a budget is used as a planning tool for how to distribute your money in future. So, before you begin budgeting, you must know the amount of money you have and how you are currently spending it. This makes budgeting very similar to doing a horizontal analysis of your income statement prior to the next period, rather than in hindsight, as would be typical with the income statement.

An effective budget will tell you three things about each item:

The total amount of money allocated to each itemThe percentage each item comprises of the total available money for the periodThe cumulative percentage of these items of the total available money for the period.

Generally this begins with the total amount of income you have available during the period. Note that we are not referring to the total amount you intend to spend, because even putting money in your savings is an allocation of your available resources; so, include your entire gross sales for the period at the top.

Disposable income

Once you have determined how much your total income is going to be for the period, calculate how much you are going to have to pay in taxes for the period, and subtract that amount. Since taxes are generally assessed on an annual or quarterly basis, calculating your taxes at this stage will be an estimate based on your expected annual income, divided across periods. It’s easiest to divide the value equally, but if you want to get a little fancy with your math, you can use a weighted average based on your productivity for the period. In any case, once you have subtracted your taxes from your total income, you are left with something called your disposable income. Since the government always gets their share, this means that part of your income is already accounted for before you formally spend it.

Your disposable income is all the income you have earned, after tax, which you are legally allowed to do with as you like.

Discretionary income

There are many things which people need to survive: food, drink, housing, clothing, some types of insurance, a minimum degree of transportation and so forth. These are not expenses which you are legally obligated to incur, as when calculating disposable income, but this is money you are obligated to spend if you enjoy surviving and would like to continue to do so, at least into the immediate future. Generally this includes all COGS items from your income statement, as well as other necessities from your operational expenses.

Once you have subtracted all these items from your disposable income, the value that remains is known as your ‘discretionary income’ – the total amount of money you have remaining to spend on luxuries and entertainment, and/or to allocate to investments and savings. As with your income statement, the individual items should be listed (or groups of similar items clustered into broad categories such as ‘entertainment spending’ or ‘equities investments’). If you have multiple savings accounts or multiple types of investments, this should be noted. In particular, if you keep a separate account for retirement investments, list it separately.

When budgeting your discretionary income for the period, the order in which you list the items doesn’t change anything, but organizing the budgeted items by priority can help you to assess more easily which expenditures are more flexible than others. This often puts retirement accounts at