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Chapter 1

Introduction to Personal Financial Planning

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Chapter Goals

Understand what personal financial planning (PFP) is and how it works.

Place goals at the head of the PFP process. Develop familiarity with PFP’s financial and personal

frameworks. Understand the specific role of financial planning and

the financial plan as comprehensive integrated processes.

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Why Is Financial Planning Important?

Many financial alternatives are available. Extensive information is available to help decide

which alternative to choose. Wise decisions enable the achievement of financial

goals. Financial planning assists in making wise decisions.

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The History of Personal Financial Planning

Before the 1970s, PFP services were generally provided to only the very wealthy.

Services began expanding to a larger population, due to: – A middle class with increased discretionary income.– The growing complexity of financial instruments and

services.– The development of PFP professionals.– Increased media awareness of PFP.

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Characteristics of Finance

Finance is concerned with the following variables:

1. Markets 5. Fair value

2. Capital 6. Cash flow

3. Market structure 7. Risk

4. Market value 8. Investments

Let’s define each of these terms:

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Characteristics of Finance, cont.

1. Markets: Places where tangible goods and financial instruments are bought and sold.

2. Capital: Real, financial and human related assets that are generated by individuals and organizations or bought and sold in the marketplace.

3. Market structures: The economic operations of the business, the government, and the household that facilitate the purchase and sale of items.

4. Market Value: The market-established worth of a product or a financial instrument.

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Characteristics of Finance, cont.

5. Fair Value: The inherent worth of nonmarketable assets based on cash flow, risk, and the time value of money principles.

6. Cash Flow: The economic operation of the organization based on the cash it generates.

7. Risk: The uncertainty of outcomes.

8. Investments: Placing cash flow into assets designed to improve an organization or to provide future funds for consumption.

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Finance Tools

Basic finance tools used when making finance decisions include:– Time value of money– Cash flow analysis– Optimization– Market pricing– Analysis of risk– Investment models of behavior

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Personal Finance

Personal finance: The study of how people develop the cash flows necessary to support their operations and provide for their well-being.

Household finance: The study of how a household and the people in it develop the cash flows necessary to support operations and provide for the well-being of its members.

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Personal Finance cont.

Personal finance issues can be placed into one of the following categories: – Consumption and savings– Investments– Financing– Risk management

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Personal Finance cont.

For example:

Personal Finance Issue Principal Category Inability to save properly Consumption and savings Debt problem Financing Desire to improve investment returns Investing Desire to retire comfortably Multiple categories Discomfort with risk profile Risk management

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Other Disciplines

Other disciplines are used in the practice of personal finance. These include:

1. Microeconomics 5. Mathematics and statistics

2. Macroeconomics 6. Business and government

3. Accounting 7. Psychology and sociology

4. Law and taxation

Let’s consider each of these disciplines:

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Other Disciplines, cont.

1. Microeconomics: Helps us understand how people and households allocate scarce resources.

2. Macroeconomics: Macroeconomic conditions often have a strong influence on household actions.

3. Accounting: Provides some of the analysis and record-keeping structures.

4. Law and taxation: Presents the rules and regulations in general, and in relation to taxation in particular.

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Other Disciplines, cont.

5. Mathematics and statistics: Yields logical thinking and appropriate measurement of household operations.

6. Business and government: Business provides a benchmark for selected household activities. Government can change the planning environment

7. Psychology and sociology: Help in understanding how people act as distinct from how they should act.

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Personal Financial Planning

Personal financial planning (PFP): The method by which people anticipate and plot their future actions to reach their goals.

When we engage in PFP, it is usually to solve a problem or to structure a plan for the future.

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Personal Financial Planning, cont.

PFP is implemented through the following six-step decision making process:1. Establish the scope of the activity

2. Gather the data and identify goals

3. Compile and analyze the data

4. Develop solutions and present the plan

5. Implement

6. Monitor and review periodically

Let’s consider each of these steps:

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Personal Financial Planning, cont.

Establish the scope of the activity – Defines the specific services that will be provided.

Gather the data and identify goals– Accumulates data on household financial assets,

income and expenditures, health, time available, and tolerance for risk.

– The underlying goal is to have the highest standard of living possible.

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Personal Financial Planning, cont.

Compile and analyze the data– Data is placed on the balance sheet, the cash flow

statement, and any other statements that are relevant. – Analysis of the statements is performed and the client’s

overall financial position is established. Develop solutions and present the plan

– Financial planner chooses the products, services, and practices that solve the client’s problem.

– The best solution is usually the one that solves the problem at the lowest cost.

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Personal Financial Planning, cont.

Implement– The best solution is chosen and put into practice. – Often difficult to accomplish due to either inertia or

difficulty. Monitor and review periodically

– All planning procedures are subject to change, due to factors such as income, financial environment, and life situation changes.

– Individual goals may also change as the client ages.

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The Financial Plan

Financial plan: The structure through which you can establish and integrate all goals and needs. – The financial plan is the practical embodiment of the

financial planning process and the tool to assist in its implementation.

Comprehensive financial plan: a detailed written financial plan, typically prepared by a personal financial planner.– Most people come to a financial planner for a solution to

individuals problems and not for a comprehensive plan.

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The Financial Plan, cont.

The financial plan is composed of the following parts:1. Establishing goals 7. Retirement planning

2. Analysis of financial 8. Estate planning

statements 9. Special circumstances

3. Cash flow planning planning

4. Tax planning 10. Employee benefits

5. Investment planning 11. Educational planning

6. Risk management

Let’s consider each of these parts:

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The Financial Plan, cont.

1. Establishing goals: Decide on priorities, both today and the future.

2. Analysis of financial statements: Present a current picture of the financial condition.

3. Cash flow planning: Plan income and expense flows so that work, cost of living, savings and investment and financing issues interact in an optimal way to provide the highest returns possible.

4. Tax planning: minimize payments to the government through allowable tax deductions, credits, and other forms of tax benefits.

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The Financial Plan, cont.

5. Investment planning: enable our net cash flows to grow as rapidly as possible, subject to our tolerance for risk.

6. Risk management: Control the level of risk and consequently of loss for each significant household asset and for the entire portfolio of assets.

7. Retirement planning: Focus on household saving and investing decisions that allow individuals to retire at the age and lifestyle that they desire.’

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The Financial Plan, cont.

8. Estate planning: Planning for yourself and others while you are alive and for current and former members of your household and other people or institutions upon your death.

9. Special circumstances planning: A miscellaneous category to handle other goals and activities.

10. Employee benefits: planning and integrating forms of compensation other than salary.

11. Educational planning: Preparing financially for the outlays for educating adult and children members of the household.

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The Financial Plan, cont.

Financial planning is more than the sum total of individual goals for each section.

Integration looks at goals and resources as a whole and at how actions in one part of the plan can affect other areas.

For example, money saved in a pension plan can increase investment sums, reduce retirement planning, and estate planning needs, and results in fewer resources available for spending today.

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The Financial Plan, cont.

Summary: Establishing goals

Analysis of financial statements

Cash flow planning, tax planning, investment planning, retirement

planning, estate planning, special circumstances planning, education

planning, risk management, and employee benefits

Financial integration

Financial plan

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Financial planning as a career

Financial planners: people with designations, education, and experience, who are trained to practice personal financial planning. Designations include:– Certified Financial Planner™ (CFP®)– NAPFA-Registered Financial Advisors – Chartered Financial Consultant (ChFC) – Personal Financial Specialist (PFS) – Chartered Financial Analyst (CFA)

Let’s consider each designation:

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Financial planning as a career, cont.

Certified Financial Planner™ (CFP®): – Offered by the Financial Planning Association.– Must take at least five courses in financial planning.– Must pass a comprehensive examination.– Must have at least three years of practical financial

experience. NAPFA-Registered Financial Advisors:

– Offered by the National Association of Personal Financial Advisors for fee-only advisors.

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Financial planning as a career, cont.

Chartered Financial Consultant (ChFC):– Offered by the American College. – For insurance agents.

Personal Financial Specialist (PFS): – Offered by the American Institute of Certified Public

Accountants.– For CPAs.

Chartered Financial Analyst (CFA):– Offered by CFA Institute– Specializes in investments.

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Financial planning as a career, cont.

Examples of the activities of financial planners:– Constructing a comprehensive financial plan.– Selecting an overall asset allocation and investments.– Implementing risk management and insurance.– Structuring and planning household cash flows.– Eliminating debt difficulties.– Helping plan for retirement.– Setting up an estate plan.– Developing goals.– Reducing taxes through planning, products and structures.

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Chapter Summary

PFP is the method by which people anticipate and schedule their future activities to reach their goals.

PFP is a six step process that begins with establishing the scope of the activity and ends with monitoring and reviewing the plan as set out.

The financial plan is a practical structure for achieving the goals set out.

Financial planning is a growing career opportunity that helps people in a wide variety of their financial pursuits.