Page 614 - Encyclopedia of Business and Finance

eobf_P 7/5/06 3:18 PM Page 591

Personal Financial Planning

this is a very general idea that may not be appropriate for of investments that perform differently during a specific
everyone. period. For example, when interest rates are low, stocks
When planning investments for one’s age bracket, usually gain while money markets do poorly.
consider the following: Every investor must find a comfort-zone balance of
security and risk. This is one of the cardinal rules of
• Security of principal: This refers to the preservation
financial planning. Ironically, the goal is to live in com-
of one’s original capital. Treasury bills (T-bills) are fort, but the key is not to get too “comfortable.” From
guaranteed by the government, while stocks fluctu- time to time investors must reconsider their earlier deci-
ate greatly.
sions and the results of those decisions to date. Investors
• Return: This means the money one earns on invest- must recognize that they should not miss out on prof-
ment (interest, dividends, profit). itable opportunities.
• Liquidity: This deals with the ease of converting
investments into cash. HOW DOES AN INVESTOR
OVERCOME OBSTACLES TO
• Convenience: This refers to the time and energy one
PLANNING?
is willing to expend on maintaining and monitoring
one’s investment. Regardless of how well a plan is developed, certain obsta-
cles are likely to arise. Four factors that could have a major
• Tax impact: Depending on one’s tax bracket, each effect on successful planning are:
type of investment will have different impact on the
taxes owed. Municipal bonds are completely tax-free 1. Inflation: To plan financially, one must receive a
if issuers are in the state of the investor, while cer- return that will outpace any long-term effects of
tificates of deposit (CDs) are fully taxable. inflation. If, for example, funds for retirement are
• Individual personal circumstances: These include such maintained in a money market account paying 2.5
factors as a person’s age, income, health, individual percent per year and over the same period the infla-
circumstances, and ability to tolerate risk. tion rate averaged 3 percent, an investment would
have less purchasing power at retirement than it did
when it was initially made.
HOW SHOULD ONE DEAL WITH
FINANCIAL RISK IN PLANNING? 2. Interest rate risk: A change in interest rates will cause
the price of fixed-rate instruments (bonds) to move
The single most important factor in deciding on the best
investments for an individual is the level of risk one can in the opposite direction of interest rates. If interest
rates go down, the value of bonds goes up, and,
afford, and is willing, to take. Thus the first step in for-
conversely, if interest rates go up, the value of the
mulating an investment plan is a careful self-examina-
bonds goes down. All types of bonds have interest
tion. How much money does a person have to invest?
What are the financial needs for the foreseeable future? rate risk. The longer the maturity of the bond, the
How much of one’s capital can be realistically invested greater the interest rate risk, so if an investor is con-
cerned about this risk, it is wise to invest in short-
with the possible risk that all of an investment might be
term instruments, such as T-bills.
a loss? What degree of risk is the individual—and the
family—willing to accept psychologically? Each of these 3. Taxation: Determining to what extent any tax-
factors will be helpful in determining the degree of risk advantaged investment would help is a serious con-
that should be tolerated when making investment deci- sideration. Factors requiring attention are tax
sions. The trade-off is simple: To get larger rewards one bracket, present income, future income, and invest-
has to take greater risks. Yet, greater risks present possibil- ment holdings at the point of undertaking financial
ity for greater losses. planning.
A person can achieve a balance by investing in a pyra- 4. Procrastination: This is an obstacle that is solely the
mid fashion: Begin with conservative (safe) investments at responsibility of the individual. There is nothing
the foundation (Treasury obligations, insured money mar- gained with the thought: “Someday I’m going to
kets, CDs) and then gradually build up, accepting a bit stop procrastinating and do something about my
more risk at each step. At the very top, an investor may future finances.” A well-designed financial plan that
have high-risk investments (e.g., coins, gold, real estate), is in one’s mind is not sufficient. If there is not con-
but because of the pyramid, these investments will be crete specification of what is to be done and if the
small compared with the rest of one’s holdings. Also, to relevant decisions are not implemented, little of
minimize loss, one should have at least two different types value is likely to follow.

ENCYCLOPEDIA OF BUSINESS AND FINANCE, SECOND EDITION 591