Personal Financial Planning

The Planning Process

A financial planning process involves figuring out where you'd like to be, where you are, and how to go from here to there. More formally, a financial planning process means the following:

• Defining goals
• Assessing the current situation
• Identifying choices
• Evaluating choices
• Choosing
• Assessing the resulting situation
• Redefining goals
• Identifying new choices
• Evaluating new choices
• Choosing
• Assessing the resulting situation over and over again

Personal circumstances change, and the economy changes, so your plans must be flexible enough to adapt to those changes yet be steady enough to eventually achieve long-term goals. You must constantly be alert to those changes but "have a strong foundation when the winds of changes shift."

Defining Goals

Figuring out where you want to go is a process of defining goals. You have shorter-term (one to two years), intermediate (two to five years), and longer-term goals that are quite realistic, as well as goals that are more wishful. Setting goals is a skill that usually improves with experience. According to a popular model, to be truly useful, goals must be specific, measurable, attainable, realistic, and timely (SMART). Goals change over time and certainly over a lifetime. Whatever your goals, however, life is complicated and risky, and having a plan and a method to reach your goals increases your odds of doing so.

For example, after graduating from university, Brittany has an immediate focus on earning income to provide for living expenses and debt (student loan) obligations. She is fortunate that her family assists her with child care. Within the next decade, she foresees going to graduate school and perhaps purchasing a house for herself and her daughter. Her income will have to provide for her increased expenses and also generate a surplus that can be saved to accumulate these assets.

In the long term, she will want to be able to retire, derive all her income from her accumulated assets, and perhaps travel around the world. To do so, she will have to accumulate enough assets to provide for her retirement income and for travel. Table 1.3.1 shows the relationship between timing, goals, and sources of income.

Timing, Goals, and Income

Timing	Goals	Income Sources
Short-Term	Reduce Debt	Wages/Salary
Intermediate	Accumulate Assets	Wages/Salary
Long-Term	Create Retirement Income	Investment Returns

Table 1.3.1

Brittany's income will be used to meet her goals, so it's important for her to understand where her income will come from and how it will help her achieve them. She needs to assess her current situation.

Assessing the Current Situation

Figuring out where you are or assessing your current situation involves understanding your present situation and the choices that it creates. There may be many choices, but you want to identify those most useful in reaching your goals.

Assessing the current situation is a matter of organizing your personal financial information into summaries that can clearly show different and important aspects of your financial life – your assets, debts, incomes, and expenses. These numbers are expressed in financial statements – in an income statement, balance sheet, and cash flow statement. Businesses also use these three types of statements in their financial planning.

For now, we can assess Brittany's situation by identifying her assets and debts and by listing her annual income and expenses; that will show if she can expect a budget surplus or deficit. But more importantly, it will show how possible her goals are and whether she is making progress toward them. Even a ballpark assessment of the current situation can be illuminating.

Brittany's assets may be a car worth about $5,000 and a savings account with a balance of $250. Her debts include a student loan with a balance of $53,000 and a car loan with a balance of $2,700. These are shown in Table 1.3.2.

Brittany's Financial Situation

Assets	Debts
Car: 5,000	Car Loan: 2,700
Savings: 250	Student Loan: 53,000
Total: 5,250	Total: 55,700

Table 1.3.2

Her annual disposable income (after tax income or take-home pay) may be $35,720, and annual expenses are expected to be $10,800 for rent and $14,400 for living expenses – food, gas, entertainment, clothing, and so on. Her annual loan payments are $2,400 for the car loan and $7,720 for the student loan, as shown in Table 1.3.3.

Brittany's Income and Expenses

After-tax income	35,720
Rent	10,800
Living expenses	14,400
Remaining for debt reduction and savings	10,520
Student loan payments	7,720
Car loan payments	2,400
Remaining for savings	400

Table 1.3.3

Brittany will have an annual budget surplus of just $400. She will be achieving her short-term goal of reducing debt, but with a small annual budget surplus it will be difficult for her to begin to achieve her goal of accumulating assets.

To reach that intermediate goal, she will have to increase income or decrease expenses to create more of an annual surplus. When her car loan is paid off next year, she hopes to buy another car, but she will have at most only $650 ($250 + $400) in savings for a down payment for the car, and that assumes she can save all her surplus. When her student loans are paid off in about five years, she will no longer have student loan payments, and that will increase her surplus significantly (by $7,720 per year) and allow her to put that money toward asset accumulation and her graduate degree.

Brittany's long-term goals also depend on her ability to accumulate productive assets, as she wants to quit working and live on the income from her assets in retirement. Brittany is making progress toward meeting her short-term goals of reducing debt, which she must do before being able to work toward her intermediate and long-term goals. Until she reduces her debt, which would reduce her expenses and increase her income, she will not progress toward her intermediate and long-term goals.

Assessing her current situation allows Brittany to see that she has to delay accumulating assets until she can reduce expenses by reducing debt (and thus her student loan payments). She is now reducing debt, and as she continues, her financial situation will begin to look different, and new choices will be available to her.

Brittany learned about her current situation by compiling two simple lists: one of her assets and debts, and the other of her income and expenses. Even in this simple example it is clear that the process of articulating the current situation can put information into a very useful context. It can reveal the critical paths to achieving goals.

Evaluating Alternatives and Making Choices

Figuring out how to go from here to there is a process of identifying immediate choices and longer-term strategies or series of choices. To do this, you have to be both realistic and imaginative about your current situation; this will allow you to see the choices you are presented with and the future choices that your current choices may create. The characteristics of your living situation – family structure, age, career choice, and health – and the larger context of the economic environment will affect or define the relative value of your choices.

After you have identified alternatives, you must evaluate each one. The obvious things to look for and assess are its costs and benefits, but you also want to think about its risks, where it will leave you, and how well-positioned it will leave you to make the next decision. You want to have as many choices as you can at any point in the process, and you want your choices to be diversified. That way, you can choose with an understanding of how this choice will affect the next choice, and so on. The further along in the process you can think, the better you can plan.

In her current situation, Brittany is reducing debt, an obligation for which she is liable, so one choice would be to continue on this path. She could begin to accumulate assets – cash or property with a monetary value – sooner if she could reduce expenses to create more of a budget surplus. Brittany looks over her expenses and decides she really cannot cut them back much. She decided that the alternative of reducing expenses was not feasible. She could increase her income, however. She has two choices: work a second job or go to Las Vegas to play poker.

Brittany could work a second, part-time job that would increase her after tax income but leave her more tired and with less time for other interests. The economy is in a bit of a slump, too – unemployment is up a bit – so her second job probably wouldn't pay much. She could go to Vegas and win big, with the cost of the trip as her only expense. To evaluate her alternatives, Brittany needs to calculate the benefits and costs of each, as in Table 1.3.4.

Brittany's Choices: Benefits and Costs

Choices	Benefit	Explicit Cost	Implicit Cost
Continue	Reduce debt	None	None
Second job	Reduce debt and increase surplus a little (more income)	None	Give up leisure pursuits
Vegas	Eliminate debt and increase surplus a lot (no debt payment)	Airfare and hotel in Vegas	Risk of increased deficit and debt

Table 1.3.4

Laying out Brittany's choices in this way shows their consequences more clearly. The alternative with the biggest benefit is the trip to Vegas, but that also has the biggest cost because it has the biggest risk: if she loses, she could have even more debt. That would put her further from her goal of beginning to accumulate assets, which would have to be postponed until she could eliminate that new debt as well as her existing debt.

Thus, she would have to increase her income and decrease her expenses. Simply continuing as she does now would no longer be an option because the new debt increases her expenses and creates a budget deficit. Her only remaining alternative to increase her income would be to take the second job that she had initially rejected because of its implicit cost. She would probably have to reduce expenses as well, an idea she initially rejected as an unreasonable choice. Thus, the risk of the Vegas option is that it could force her to "choose" alternatives that she had initially rejected as too costly.

 

Chart 1.3.1 Considering Risk in Brittany's Choice

The Vegas option becomes least desirable when its risk is included in the calculations of its costs, especially as they compare with its benefits.

The obvious risk is that Brittany will lose wealth, but the even costlier risk is that it will limit her future choices. Without including risk as a cost, the Vegas option looks attractive – which is, of course, why Vegas exists. However, when risk is included and when the decision involves thinking strategically not only about immediate consequences but also about the choices it will preserve or eliminate, that option can be seen in a different light.

Brittany's Choices: Benefits and More Costs

Choices	Benefit	Explicit Cost	Implicit Cost	Strategic Cost
Continue	Reduce debt	None	None	Preserves alternatives
Second job	Reduce debt and increase surplus a little (more income)	None	Give up leisure pursuits	Preserves alternatives
Vegas	Eliminate debt and increase surplus a lot (no debt payment)	Airfare and hotel in Vegas	Risk of increased deficit and debt	Eliminates alternatives

Table 1.3.5

You may sometimes choose an alternative with less apparent benefit than another but also with less risk. You may sometimes choose an alternative that provides less immediate benefit but more choices later. Risk itself is a cost and choice a benefit, and they should be included in your assessment.