Managing Personal Finance; Philosophy in Personal Finance

A Student Guide for ABM124 Students

I. Ten Principles that form the Foundations of Financial Management

1. Principle 1: The risk-return tradeoff - we won't take additional risk unless we expect to be compensated
with additional return. Almost all financial decisions involve some sort of risk-return tradeoff.

2. Principle 2: The time value of money - a peso received today is worth more than a dollar received in
the future.

3. Principle 3: Cash -- Not Profits -- is King. In measuring value we will use cash flows rather than
accounting profits because it is only cash flows that the firm receives and is able to reinvest.

4. Principle 4: Incremental cash flows - it's only what changes that count. In making business decisions,
we will only concern ourselves with what happens as a result of that decision.

5. Principle 5: The curse of competitive markets - why it's hard to find exceptionally profitable projects. In
competitive markets, extremely large profits cannot exist for very long because of competition moving
in to exploit those large profits. As a result, profitable projects can only be found if the market is made
less competitive, either through product differentiation or by achieving a cost advantage.

6. Principle 6: Efficient Capital Markets - The markets are quick and the prices are right.

7. Principle 7: The agency problem - managers won't work for the owners unless it's in their best interest.
The agency problem is a result of the separation between the decision makers and the owners of the
firm. As a result managers may make decisions that are not in line with the goal of maximization of
shareholder wealth.

8. Principle 8: Taxes bias business decisions.

9. Principle 9: All risk is not equal since some risk can be diversified away and some cannot. The process
of diversification can reduce risk, and as a result, measuring a projects or an asset's risk is very
difficult.

10. Principle 10: Ethical behavior is doing the right thing, and ethical dilemmas are everywhere in finance.
Ethical behavior is important in financial management, just as it is important in everything we do.
Unfortunately, precisely how we define what is and what is not ethical behavior is sometimes difficult.
Nevertheless, we should not give up the quest.

II. Money Management Cycle

Earn

Invest Spend

Save

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Earning, Spending, and Saving: The Building Blocks of Personal Finance

Smart personal finance can be reduced to one simple equation:

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 [WEALTH] = [WHAT YOU EARN] [WHAT YOU SPEND]
If you spend more than you earn, you have a negative cash flow. Youre losing wealth and in danger of going
into debt. (Or, if youre already in debt, youre digging the hole deeper.) If you spend less than you earn, you
have a positive cash flow, which will let you climb out of debt and build wealth.
Basic personal finance comprises three essential skills:
Earning your ability to bring in money.
Spending your ability to live frugally and spend wisely.
Saving your ability to produce a surplus and to make that surplus grow.
Some folks are good at one skill, but not the others. (Maybe youre good at keeping your costs low, for
instance, but struggle to earn money.) Other people are good at two of the skills, but fall down on a third. (You
might have a good income and keep your costs low, but have a small nest egg because you lack skill in saving.)
And still others are passable at all three skills not really excelling, but not failing either.
To be truly successful at personal finance, you have to maximize your performance in all three areas.
A. Mastering the Art of Earning

The first skill in this framework is your ability to make money. For most folks, this means managing a career
effectively: finding the right job, learning how to ask for a raise, and so on. Others can up their incomes by
selling stuff they already own, pursuing money-making hobbies, or starting their own businesses.
Here are some steps that lead to increased earnings:
Become better educated. In general, the better your education, the better your income.

If possible, choose a career that you love and that pays well. This isnt always possible, of course. But if
you can get paid well to do what you love, it can almost be like you dont have a job at all!
Maximize your salary. This is probably your primary source of income, so make the most of it. Learn how
to negotiate your salary. Make the most of your benefits.
Make money from your hobbies. Find ways to earn a little cash from the things you do in your spare time.

Turn your clutter into cash. When youre trying to get out of debt, you may sell some of your stuffs. You
may not get back what you paid for them, but thats okay. You got out of debt, which was even better.
Though some people dont like to hear it, high income is also associated with hard work. The folks who make
the most money are often those who work the longest hours. Hard work doesnt guarantee a high income,
of course there are plenty of hard workers stuck in low-wage jobs but its tough to master
the art of earning without hard work.
And heres another reason to enhance your earning power: As vital as it is to cut your spending, theres only
so much you can trim from your budget. Your income, on the other hand, is theoretically unlimited.
If life were a game, your earning score would be easy to calculate: Itd simply be a measure of your annual
income. The more you made, the higher your score.
B. Developing Discipline in Spending

While some people find it tough to boost their incomes, others find it tough to keep costs down. There are
even those who believe that thrift is overrated, that its somehow akin to deprivation. But those who dismiss
frugality to focus solely on earning are missing a key piece of the puzzle. Your goal should be to create as
big a gap as possible between earning and spending.
How do you do that?

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 Embrace frugality. A lot of folks are afraid to pinch pennies they dont want to appear cheap
but frugality is an important part of personal finance. Learn to clip coupons, shop at sales, and make do
with less.
Practice conscious spending. You cant always get what you want, so decide whats important to you, and
make those things a priority. Cut corners on the things that dont matter.
Avoid paying interest. The power of compound interest can help you build wealth when its on your side.
But it can suck you dry if its working against you. To cut your interest payments, Get out of
debt and stay out of debt. Make it a goal to pay as little interest as possible.
Reduce recurring expenses. One-time costs can be painful, but ongoing expenses like magazine
subscriptions, cable television and cell-phone bills, etc. can act like an anchor on your finances.
Focus on the big wins. Daily frugality is a valuable skill. It helps you save a little bit all the time. But if
you really want to cut your spending, spend less on the big things, like housing and transportation.
If personal finance were a game, your spending score would come from how low you could go. The less you
spent, the higher your score.
Remember: Your earning power might bring you wealth; frugality and thrift will help you keep
it. By cutting your spending while you increase your income, youll develop a cash surplus a surplus that
can be used for saving.
Note: If you embrace frugality but ignore your income and investments, you cant expect to build wealth.
Each skill is essential.
C. Discovering the Secret of Saving

The surplus (difference between what you earn and what you spend) is important, no question it forms the
foundation of your ability to save but skill at saving comes mainly from what you do with your
surplus.
If you hide your money under a rock, for instance, your skill at saving isnt particularly good. Anyone can do
that. And though you might think youre protecting what youve saved, youre actually losing money to
inflation, the silent killer of wealth. (If you use your extra money to play the lottery, your savings skills are
especially poor!)
What sorts of things go into becoming a successful saver? This is where knowledge of investing pays
dividends. The secret of saving is to learn everything you can about making your wealth grows. Successful
savers:
Understand the importance of creating a plan and sticking to it. (This is where asset allocation and re-
balancing come into play. Ill write about these more later in the month.)
Make logical decisions instead of succumbing to emotion. Successful savers dont make decisions based
on breathless media pundits.
Avoid fads. They dont buy real estate just because everyone else is. They dont buy tech stocks just
because theyre riding high. And theyre wary of gold when its at record highs. They buy low and sell high.
Embrace diversification as a way to improve returns while reducing risk.

Constantly contribute their surplus income to grow their savings. They pay themselves first.

If there were a scorecard for life, your points for saving would be determined by how much you make your
surplus grow, and by how well you protect the money you save.

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 The Fundamentals of Personal Finance
None of this is earth-shattering; these notions form the core of smart personal finance. What is new for me,
anyhow is thinking of earning, spending, and saving as discrete skills, building blocks that can be put
together to form a greater whole. Its this framework thats new.
Mastering money means mastering each of these three skills. If you can teach yourself all about
earning, spending, and saving and put what you learn into practice youll achieve your financial aims with
surprising speed. But so long as one of these skills lags, youll struggle to meet your goals.
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D. Investing: The 4 Best Personal Investments Millennials Can Make
(Note: This is an extended version of Discovering the Secret of Saving found in pp. 3-4)

A quick search reveals tons of investment advice: in the stock market, in retirement accounts, in FOREX or
commodities or gold all designed to help you get a positive return on your time and your money.
But theres one major investment category that typically is not mentioned: Investing time and money in
yourself.
Of course you shouldnt ignore other forms of investing, but taking twenty to thirty minutes each day to invest
in yourself will generate much greater long-term results than any other investment you might make.
How?
1. Build an awesome and genuine personal network.
Actually, you have hundreds of Instagram and Twitter followers, and plenty of Facebook friends, too. Thats
greatbut what about truly personal connections?
Social media connections are occasionally useful, but the best connections are always personal. Who can you
depend on if you need a recommendation (or a new job)? Who can you depend on when you need honest,
objective professional guidance? Who can you depend on when you need a favor? Your Twitter friends are
unlikely to be there for you but people with whom youve made a genuine connection just might.
How to invest: Spend a few minutes every day reaching out by email or phone, not through social media, to
peers or customers or colleagues or fellow alumni or anyone you want to compliment or praise. Spend a few
minutes giving you may never receive in return, and thats okay, because feeling good about helping
someone else is, in itself, worth the effort.
2. Actively expand your horizons.
The only way to think outside the box is to occasionally live outside of your typical box. The only way to live
your life differently than other people is to actually live differently, at least some of the time. Doing a few
things you normally would never do is the perfect way to find new opportunities, grow your network, and
discover opportunities you never knew existed.
How to invest: Get a part-time job, one outside your field. Take a class in an area outside your expertise.
Pick something outside your comfort zone and do it in the process youll learn and grow and gain
confidence... and realize that your potential is much greater than you ever imagined.
3. Start a side business.
Focus is important, but so is flexibility and openness. Maybe you have programming skills you arent using.
Maybe youd like to sell a few products online. Maybe youd like to teach or tutor or mentor. All you have to
do is take something youre interested in and turn it into a small business. While you may make some money,
more importantly youll leverage your interests, broaden your business perspective, possibly bring some of
what you learn back to your career and get hands-on experience with being an entrepreneur.

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Entrepreneurial skills are always in demand.
How to invest: Pick something you like to do and dream up a few ways to make money doing it. Again, the
goal isn't to get rich (although you might); the goal is to take on a challenge and learn to conquer it all
while gaining extremely useful business skills.
4. Spend time every day thinking.
You think that you spend your whole day thinking.
But actually you dont. You spend your whole day reacting to issues, to requests, to targets and goals and
hurdles reacting is thinking, but its a very different type of thinking. What you dont get to do is think
strategically: about your future, about how best to reach your goals, about how to better work with the
people around you that kind of thinking is incredibly productive. In my experience, the difference in
successful and unsuccessful people is partly based on the fact that successful people set aside time to just
think.
How to invest: Turn off all the distractions. Turn off the TV or music. Take a walk. Or sit quietly and gaze at
your favorite view. Force yourself to simply be by yourself with your own thoughts.
It might be boring at first, but boredom is a great source of inspiration. Before you know it the ideas will flow,
and theyll be your ideas and those are the best ideas of all.

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