Personal Finance – 10 Principles of Personal Finance for Better Real Estate Investing:
Understanding the principles of finance is key to successful investing. Personal Finance: Turning Money into Wealth (6th Edition) identifies ten principles that form the foundation of personal finance:
Principle 1: The Best Protection is Knowledge
An understanding of personal finance will:
• Enable you to protect yourself from bad investment advice.
• Provide you with an understanding of the importance of planning for your future.
• Give you the ability to make intelligent investments and take advantage of changes in the economy and interest rates.
• Allow you to extract the principles you learn and apply them.
Principle 2: Nothing Happens Without a Plan
• Begin with a simple plan then once saving becomes a habit, modify and expand your plan.
Principle 3: The Time Value of Money
•Perhaps the most important concept in personal-finance is that money has a time value. Simply stated, because you can earn interest on any money received, money received today is worth more than money received later.
•The importance of the time value of money is twofold: 1) It allows us to understand how investments grow over time. 2) It allows us to compare dollar amounts in different time periods.
•Early in your financial life cycle you may borrow money to buy house. In taking out a home mortgage, you are spending money today and paying later. In saving for retirement, you’re saving money today and spending it later. In each case money is moved through time. You either spend in today’s dollars and pay back in tomorrow’s dollars or save in today’s dollars and later spend in tomorrow’s dollars.
•To create wealth, we invest savings and allow it to grow over time. In fact, much of personal-finance involves efforts to move money through time.
Principle 4: Taxes Affect Personal Finance Decisions
• Taxes help determine the realized return of an investment.
• No investment should be made without first knowing effective taxes on the return of that investment.
Principle 5: Stuff Happens, or the Importance of Liquidity
• Plan for the unexpected. This means that some of your money must be available to you at any time, or liquid.
• If liquid funds are not available, an unexpected event such as a change in the economy or job loss may push you to have to cash in a longer-term investment, for example selling a rental property.
• And what if you don’t have something to sell? In that case you’ll have to borrow money fast and that kind of borrowing may carry a high interest rate.
• Unplanned borrowing is just one reason to have adequate funds to cover 3 to 6 months living expenses.
Principle 6: Waste Not, Want Not — Smart Spending Matters
• Personal-finance and managing your money involves more than just saving and investing—it also involves smart spending.
• The four steps of smart buying are: (1) differentiating want from need and understanding how each purchase fits into your life. (2) doing your homework to make sure what you get the quality you expect. (3) making a purchase and getting the best price (4) maintaining your purchase.
Principle 7: Protect Yourself Against Major Catastrophes
• To avoid the consequences of a major tragedy you need to buy the kind of insurance that’s right for you and know what your insurance policy really says.
• The focus of insurance should be on major catastrophes-those events that although remote, can be financially devastating. Hurricanes, floods, earthquakes and fires are examples. These are the events you can not afford, and these are the events insurance should protect you against.
Principle 8: Risk and Return Go Hand-in-Hand
• People generally save money and invest in order to earn interest and grow their money so they will have even more money in the future.
• Typically investors demand a minimum return greater than the anticipated level of inflation. Why? If inflation is expected to be 6% and the expected return on the investment are only 2%, then the return isn’t enough to cover the loss of purchasing power due to inflation. That means the investor has, in effect, lost money and there’s no sense in making an investment that loses money.
• While all investments have risk some are safer than others. Why would an investor put their money in a risky investment when there are safer alternatives? They won’t unless they are compensated for taking that additional risk. In other words, the greater the risk, the greater the return an investor expects to receive.
• Diversification is the acquisition of a variety of different investments instead of just one. Diversification lets you reduce, or diversify, some of your risk without affecting your expected return.
Principle 9: Mind Games, Your Financial Personality, and Your Money
• Behavioral biases can lead to big financial mistakes.
• Mental accounting for example refers to the tendency for people to separate money into different accounts, or buckets, each with a different purpose as the following examples illustrate: (1) Keeping money in a savings account that pays 3% interest, while not paying off your credit card that charge you 14% interest. (2) When you get your tax return and view it as mad money and promptly go out and spend it, while at the same time you’re pinching pennies to save for your child’s education.
• Sunk Cost Effect— once we put money into something, we become attached to it and are more likely to spend good money after bad money.
• Many people seem financially wired in ways that make it hard to save while others find it hard to spend. Our views on spending and saving and whether we have a fear of money-related issues resulting in the tendency to “just not think about it” will go along way toward determining our financial success.
Principle 10: Just Do It!
• Making a commitment to actually get started maybe the most difficult step in the entire personal financial planning process.
• Pay yourself first— when you pay yourself first, what you spend becomes residual. That is, you first set aside your savings, and what is left becomes the amount you can spend—that’s the first step in putting your financial plan into action.
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