What to do with your cash? How much of your money do you keep in short-term accounts and how much in long-term accounts? Do you keep gold or foreign currency at home?
When was the last time you were undecided between different investment options? Has it ever happened that insurance advisors introduced you to various coverages, making you think about how much of your income should be spent on buying insurance coverage?
Such questions have always been posed to individuals and families. However, they usually become more serious concerns during periods when the economy is unfavorable. High inflation, economic recession, price fluctuations, and uncertainty about the future make financial decisions more central to people’s attention.
For this reason, it is natural that in recent years, attention to such issues has become more prominent, and personal financial planning has received more attention than in the past.
What is Personal Financial Planning?
Everyone wants to maintain and improve their standard of living. Everyone wants to improve the way they live. This is impossible just by working more. So, how money is managed, living expenses are taken care of, the value of money is maintained, and maybe even investing. Our attitudes about money and incomes and our behavioral habits regarding financial and monetary matters can be very important parts of our economic status.
Personal financial planning defines all problems related to income, expenses, and assets, including keeping and managing them throughout one’s lifetime.
It is important to underline that personal financial planning does not only concern an individual. It also involves the economy and financial status of the family. The mere reason for mentioning the word “personal” near this term is the difference between financial planning for companies and businesses.
Major Topics in Personal Financial Planning
Personal financial planning is, as explained earlier, the art of keeping and managing income, expenses, and assets. Hence, the following topics outline discussions of personal financial planning. (To give more detailed examples of the issues, a few questions—such as the ones below—are mentioned.)
How much income do I have in the upcoming months (and years)? What are my monthly living expenses?
How will my income and expenses change over the upcoming months and years?
What are my financial goals in life? How much income will satisfy me?
How should I define my monthly budget? What should I include in it?
What portion of my income can I save?
Invest
How should I invest my savings?
What fraction of my money should be kept with the bank? And, more specifically, which bank and in which accounts are most appropriate for me?
How much of my savings should I hold in my company’s shares?
Insurance
What tools should I use to insure and cover life risks?
Which insurance policies should I apply for?
What level of insurance coverage is appropriate for health and my family’s health?
What level of insurance coverage is appropriate for home, car, and household items?
What level of insurance coverage is required for my retirement?
What percentage of my income shall use to take insurance?
Taxes
How much must I pay in monthly (and yearly) taxes?
What are the country’s tax laws, and what will the future of tax laws look like?
How should I manage my assets to avoid falling victim to the weaknesses of the tax system? (Tax systems in any country cannot allocate taxes completely fairly, and there are always some people who fall victim to legal weaknesses).
Crisis Management
If I quit my job (or am fired), what is my short-term plan regarding the living expenses I will incur during the non-employment transition period?
What are my choices regarding severe illnesses affecting me or a family member?
Retirement planning
What do I plan to do in the years that I will not be able to carry out any more productive work?
What is the cost of living during that period?
Where can I get my financial needs secured during my retirement?
To what extent can I count on my retirement benefits?
Allocation, Property Transfer, and Death
Under whose name should family assets be? In what ways can proper asset allocation increase security and peace of mind? What should we predict that if my spouse and I decide to separate, the least tension and hardship are created for either one of us, and financial tensions do not add to this emotionally? What will proper planning be for the legal gaps and weaknesses in property transfer (such as inheritance, etc.)? What will happen to my assets and property after my death?
History of the Formation of Personal Financial Planning
Characteristically, from the very day humans acquired something known as money and assets, they also pondered over personal financial planning. However, the personal financial planning that we know today has existed for a little over half a century and is the consequence of the space of the sixties and seventies in the American economy.
The late sixties and early seventies were eccentric years for the American economy. The country was engaged in the Vietnam War and was facing economic and psychological pressures. On the other hand, OPEC, led by Iran and Venezuela and with the cooperation of Iraq, Kuwait, and Saudi Arabia, had gathered strength and was exerting its influence on energy prices in global markets. Inflation in the US economy touched 6% after roughly two decades, which was perceived as a significant figure. The Arab− Israeli war also motivated Middle Eastern nations to boycott the United States, and the economy of this country came under further pressure from oil sanctions (1973 and 1974).(+)
In such conditions, during a time of recession, inflation, and political and economic uncertainties, American families were involved in discussing how to conduct their financial aspects of life. During those last days of 1969, thirteen people gathered in Chicago, USA. They put the question before themselves: “How can various fields of knowledge that have taken shape around financial discussions be brought together to create a professional specialization that helps people better use financial and credit services?”(+)
The result of these work and activities was the establishment of the International Association of Financial Planners (IAFP), which began its work with educational courses.
These courses taught financial planning, and it was assumed that graduates could advise people on planning their financial lives. Due to these courses, the term CFP (Certified Financial Planner) also became popular.
The economic turmoil of the 1970s and people’s economic concerns provided a good opportunity for the rise of CFP, and “personal financial planning” emerged as a perfectly fitting specialization. This specialization now has over fifty years of history and is considered a completely formal and professional activity.
In recent decades, the importance of financial literacy and personal financial planning has been more recognized than ever before, so nowadays, many universities have included this topic in their curricula.
Knowledge, skills, and abilities relating to financial planning
We think about someone who wants to do quality personal financial planning correctly. What do they need to know? What skills do they require? Which abilities are required? In this regard, it is impossible to provide a comprehensive list. However, by reviewing reference books on financial planning, to some extent, the answer to this question can be obtained.(+)
Psychology of Money
Knowing the psychology of money is one of the basic building blocks of personal financial planning. Our attitude towards money, money scripts, mental accounting methods, and the hierarchy of values almost overshadow our financial decisions.
If any financial strategy works fine for your friend and satisfies him, why should that financial strategy work for you, too? Similarly, if your colleague has stepped into the forex or digital currency markets and has made good money, that does not translate into the fact that entering these markets is also good for you. Similarly, if you have friends who have some of their money saved in long-term savings accounts, you cannot tell them that it is a mistake and that if it were me, I would never do this.
Financial decisions have several bases: who keeps which money in which economy and for what purpose — earning, retaining, spending, investing. Suppose you change the “who,” your judgments and ratings may change completely. What you thought was right may turn out to be wrong, and a decision that seemed immature may be justified.
Key Financial Statements
To plan financially, we need to be able to prepare and maintain our balance sheets. We also need to record our cash flow reports and review them regularly.
For typical living (not scattered properties in multiple cities and countries or bank accounts on different continents), such formal and strict accounting standards are not necessary.
But it’s important to have transparent financial records. Assets and liabilities should be clear, and assets and liquidity should be completely separate (do you know anyone who has an expensive car but if the car mirror breaks or they have an accident, they have to stop using the car for a long time until they can afford to repair it? This is a simple example of the difference between assets and liquidity).(+)
Time preference is one of the key concepts of financial calculations. You can productively make some work with money. Money can be given to work, and its volume increases. Money can remain in banks doing nothing and not losing value with minimum interest. Thus, amount X of money today does not equal amount X ten years later. Therefore, if a person invests money in a business and recovers the same amount within five or ten years, that person cannot claim that “my account is zero. At least the money I invested in my business has returned to me.” Understanding the time value of money is necessary for the evaluation of financial decisions and the comparison of investment opportunities.
Concept of Risk
In financial activities, risk and profit cannot be completely separated. Someone who wants more profit must also bear more risk.
However, many people do not pay attention to this simple concept. For example, someone entering the stock market knows that they must also bear much higher risks if they want to receive much higher profits than bank deposits. But usually, during bullish years in the stock market, we see many people who do not understand these relationships, simply entering the stock market by comparing bank profits with the average stock market profits (or worse, profits earned by an acquaintance).
Many individuals’ economic losses result from their seeing profit and risk as independent: potential profit attracts them without recognizing or evaluating its risk.
Portfolio Management
We have all heard the phrase “Don’t put all your eggs in one basket.” to the extent that it has become a proverb. But if we have ten baskets and ten eggs, blindly putting one egg in each basket is just as immature: portfolio management is about the knowledge and skill of allocating eggs to baskets appropriately.
This definition of portfolio management is the simplest and, at the same time, the most inaccurate. But for now, introducing the concept of personal financial planning is sufficient.
If you want to keep a portion of your money in cash, put another portion in a short-term account and another in a long-term account. At the same time, buy some foreign currency and gold and have a car under your feet, but still don’t know how much money to allocate for each task. Financial experts say you are facing the issue of portfolio management.
Prosperity and recession in markets
Prosperity and recession are fundamental features of markets. Because these features are inherent in the market structure (delay in harvest, friction in transactions, incomplete and asymmetric information, etc.), it is unimaginable to find a market in the real world without these cycles.
Anyone who wants to manage their assets optimally must understand the concept of prosperity and recession and its dynamics and pay attention to it. Otherwise, they may fall victim to excessive optimism and pessimism.
Foundations of Behavioral Finance
One of the most important achievements of economics and psychology in recent decades has been that humans are not rational in their economic decisions. The being economists speak of in their classic formulas and analyze its behavior based on traditional logic does not exist.
Sometimes, to buy something a little cheaper, we burn several times more gasoline and go to a distant shopping center. Sometimes, because we cannot distinguish the quality of products, with the price increase, we assume the quality is better and our desire to buy more increases (in the traditional view, a price increase should decrease demand). The grief of losing a certain amount of money is not proportionate to the joy of gaining it.
All this means that traditional economics alone is insufficient to understand our behavior, and psychology and behavioral science must also help. The result of this combination is behavioral finance, and anyone who wants to plan their finances properly must understand the foundations of behavioral finance.