Success in Personal Finance requires doing a number of smart things and avoiding big mistakes.
Proverbs tells us “The blessing of the Lord brings wealth . . . ” (10:22) and warns “. . . give me neither poverty nor riches . . . otherwise I may have too much and disown you . . .” (30:8).
We are not going to talk about getting rich, for it probably contains more dangers than blessings, but we are going to explore the process of good money management, how to do smart things and avoid the big mistakes.
To do your own personal financial planning–successfully–you need goals, knowledge and discipline. In the next article we learn how to establish specific goals. Throughout all the articles we hope to reveal biblical principles and financial factors that will motivate you to exercise the requisite degrees of discipline. We start the knowledge part with an understanding of the dynamics of personal financial planning. What is science and what is art? We will build on this knowledge in each article.
Dynamics of Finance
Risk, Return, and Time are the variables that, when in appropriate balance, give us the level of return we need to accomplish our goals.
We tend to start with return, but we should start with risk, the most subjective of the three variables. You should consider risk when evaluating various rates of return over specific periods. Institutions compensate you for taking risk with either guaranteed returns (interest on term investments) or the potential for return (ownership of equities such as stock and stock mutual funds). You earn return by taking risk and they should go up together.
The 90 day U.S. Treasury Bill is the world’s definition of zero risk. The holding period is too short to have a liquidity risk and nothing in the financial world is more secure than a U.S. Treasury Bill. Liquidity is the ability to sell or liquidate a holding so liquidity risk is what you take when you give up that ability for a period of time. The other end of the risk spectrum is more difficult to establish.
Suffice it to say, there are many examples of investments that offer huge potential returns and even greater risk. We will eliminate the extremes and consider the type of returns that, over time, can be expected to offer a reasonable return for a risk that lets you sleep and will not threaten your financial security. We will look at these in articles 4 & 5, “Phases of Planning and Portfolio Theory” and “Investing and Markets.”
For now, let me say that risk exists at three levels. First, you fail to achieve the return you planned on to reach an objective. Usually, you have to save/invest more. Second you lose part of your principal and have to modify several elements of your plan: save more, delay or downsize objectives. Finally, you lose so much that family security is jeopardized. You probably have to change objectives and significantly modify lifestyles. Few, if any, objectives justify risking family security, unless you hear it clearly from our Lord.
Time is the third variable to be balanced with risk and return. With term investments, you lock up money in investments (like certificates of deposit) that either reward you with regular competitive returns or penalize you if interest rates rise and you are stuck with what has become a non-competitive rate of return.
We call this liquidity and because you give it up on a five-year CD, institutions pay more to compensate for this risk. Still, you have taken another kind of risk, an opportunity cost that your money invested elsewhere might have returned more. We will look at balancing these factors in the next three articles.
Time can also reduce risk in the case of mutual fund or stock holding. The volatility of the markets can cause losses over relatively short (one to three year) periods, but during none of the thirty-one ten-year periods, 1960-99, has the market (as measured by the S&P 500) had a negative period. Only two of thirty-six five-year periods have shown losses (1960-69 is a ten-year period. 1961-70 is a second and so on).
In fact, time, combined with interest, presents us with both the best and the worst scenarios. It can work for you, producing spectacular results on your investments, or against you, costing you dearly on your debt. First the bad news.