PART 4: TWELVE KEY ELEMENTS

OF PRACTICAL PERSONAL
FINANCE

Common Sense Economics ~

What Everyone Should Know About
Wealth and Prosperity
1

http://CommonSenseEconomics.com/ Turn on the learning light!

INTRODUCTION TO POWERPOINT
SLIDES
 The PowerPoint slides for the Common Sense Economics (CSE) electronic
package provide an overview of the most important points covered in the
text. Students should read the text, watch the assigned videos, and listen to
the podcasts prior to reviewing the slides.
 The PowerPoint slides are organized by module, which reflects the
approximate amount of material most instructors will cover weekly during a
regular school term. The 15 core modules cover all of the CSE text.
Modules 12, 13, 14, and 15 covering part 4 of CSE are presented here. The
slides for each module are organized as follows: (1) module title and list of
concepts covered, (2) highlights and explanation of text material, including
the CSE elements covered by the module, and (3) questions for thought.
 Some instructors may want to use the PowerPoint slides for classroom
instruction. The slides will provide students with a comprehensive set of
notes and explanatory material for the CSE text.
2
MODULE 12: EARNING, BUDGETING,
AND SPENDING WISELY
 CSE Part 4, Elements 1, 2, and 3
 Concepts Covered:
 Comparative advantage and discovery of career opportunities
 Entrepreneurship, productivity, and personal success
 Attitudes, productivity, and personal success
 Budgeting and getting more out of your income

3
FINANCIAL ANXIETY OF AMERICANS
 Compared to Americans a couple of generations ago and
their contemporaries worldwide, Americans have
incredibly high incomes. Yet, many are under financial
stress. Why?
 Most Americans spend without a plan, save very little and are
heavily indebted. Financial insecurity is mainly the result of
the choices we make, not the incomes we earn.

4
PLANNING FOR FINANCIAL SUCCESS
 If you do not take charge of your finances, they will take
charge of you.
 As Yogi Berra, the great American philosopher (and late
baseball star) said, “You’ve got to be very careful if you don’t
know where you are going, because you might not get there.”

 Each of us needs a plan. The twelve elements in this part

form the core of a practical plan. They will help you
make better financial decisions whatever your current
age, income level, or background.

5
THOUGHTS ON THE IMPORTANCE OF
MONEY AND WEALTH
 There is more to a good life than making money. When it
comes to happiness, nonfinancial assets such as a good
marriage, family, friends, fulfilling work, religious
convictions, and enjoyable hobbies are more important
than money.

 However, there is nothing wrong with a desire to make

more money and spend it wisely. No matter what our
objectives in life, they are easier to achieve if we have
higher earnings, less debt, and more wealth. Thus, all of
us have an incentive to improve our financial decision-
making. 6
ELEMENT 1. DISCOVER YOUR
COMPARATIVE ADVANTAGE.

7
DISCOVER YOUR COMPARATIVE
ADVANTAGE
 You need to take charge of your career development and
plan how you can best develop your talents and use
market cooperation to achieve your goals. No one else
cares more about your personal success than you do.
Neither does anyone else know more about your
interests, skills, and goals.

 No matter how talented you are, you will be relatively

more productive in some areas than others. You need to
discover those areas where you have a comparative
advantage.
8
THINKING ABOUT YOUR CAREER
 Two factors that are crucially important when making
career choices.
1. You need to develop skills and cultivate attitudes that will
enhance your ability to provide others with goods and services
that they value highly. People earn income by helping others.
If you want to achieve earning success, you need to figure out
how you can help others a lot.
2. You need to discover where your passions lie—those
productive activities that provide you with the most
fulfillment. Competency and passion for an activity go
together. If you enjoy what you do and believe it is important,
you will be happy to do more of it and work to do it better.
Moreover, real wealth is measured in terms of personal
fulfillment. 9
ELEMENT 2. CULTIVATE SKILLS,
ATTITUDES, AND ENTREPRENEURSHIP
THAT INCREASE PRODUCTIVITY AND
MAKE YOUR SERVICES MORE
VALUABLE TO OTHERS.

10
PRODUCTIVITY AND EARNINGS
 How can you increase your productivity, and therefore
your earning power?
 Improved knowledge, higher skill level, and experience
generally increase productivity and enhance one’s ability to
provide valuable services to others. As a result, investments
in human capital—education, training, and other forms of
skill acquisition—can improve both productivity and
earnings.

 But, other personal attributes also influence productivity.

Two of the most important are personal attitudes and
thinking entrepreneurially.
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CULTIVATING ATTITUDES THAT WILL
IMPROVE YOUR PRODUCTIVITY
 Success oriented attributes:
 honesty, dependability, persistence, reliability,
trustworthiness, respect for others, desire to learn and
improve, and ability to work with others.

 Failure oriented attitudes:

 disrespectfor others, unreliability, quarrelsome, contempt for
education, vulgarity of speech, blaming others for problems,
dishonesty, and reliance on alcohol and drugs.

12
CULTIVATING ATTITUDES THAT WILL IMPROVE
YOUR PRODUCTIVITY CONTINUED…
 If you want to be successful, you need to cultivate,
develop, and strengthen the first set of attributes.

 They need to become habits—the core values of your

life. Equally important, you need to cast the second set
out of your life. Do not let anyone, including friends,
convince you that any of the failure attributes are “cool”.

13
CULTIVATING THE ENTREPRENEURIAL
WAY OF THINKING
 Entrepreneurial thinking is also a personal attribute that
can enhance your productivity. While entrepreneurship is
often associated with business, in a very real sense all of
us are entrepreneurs. We are constantly making decisions
about the development and use of knowledge, skills, and
other resources under our control.
 Entrepreneurial thinking focuses on how to develop and
use talents and mobilize available resources to provide
others with things that they value highly.

14
CHARACTERISTICS OF SELF-EMPLOYED
ENTREPRENEURS
 Self-employed entrepreneurs are disproportionately
represented among the financially successful.
 Four major factors contribute to the financial success of
self-employed entrepreneurs. They:
1. identify and act on attractive opportunities overlooked by
others,
2. have a willingness to take risk,
3. have high rates of saving and investment, and
4. have a willingness to work long hours because they love
what they do.

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EMPLOYEES AND ENTREPRENEURIAL
CHARACTERISTICS
 Employees can also make choices like those of
successful entrepreneurs. They can:
 focus on making their services valuable to employers, both
current and prospective.

 investtheir savings in stocks and thereby achieve the above-

average returns that come with the risk of business
ownership.

 generate more income and accumulate wealth through higher

rates of investment and more hours of work.
16
DEVELOPMENT OF TALENTS AND
EARNED SUCCESS
 Development and use of your talents in ways that
provide large benefits to others is a key to financial
success.

 It is also central to what Arthur Brooks calls “earned

success.” Moreover, earned success is the central
element of happiness and life satisfaction.

 Earned success is present when your education, work,

and lifestyle choices reflect the purpose of your life.
17
ELEMENT 3. USE BUDGETING TO HELP
YOU SPEND YOUR MONEY
EFFECTIVELY AND SAVE REGULARLY.

Money is only a tool. It will take you wherever you

wish, but it will not replace you as the driver.
—Ayn Rand

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WHAT IS BUDGETING?
 What is the purpose of a budget?
 A budget is an instrument that will help you channel your
funds toward sound spending, regular saving, and diversified
investments in a manner that will provide you with the most
value from your income.

19
WHAT IS BUDGETING? CONTINUED…
 Effective budgeting is an ongoing process, not a one-
time event. It is comprised of two specific actions.
1. You must create the initial budget which is simply a
document that identifies all of your planned or expected
spending for a period of time, generally a month.

2. You need to keep track of your actual spending and make

needed budget adjustments. This will provide you with a
feedback mechanism that will help you develop a better,
more precise budget in the future.

20
IMPORTANCE OF SAVING IN YOUR
BUDGET
 Saving and investment should be specific items in your
budget, not just a leftover balance.
 You need to save for unexpected expenditures, repayment of
outstanding debts, down payments for large purchases, the
achievement of important goals, and retirement.

 Consuming less and saving more today will make it

possible for you to consume more in the future.

 Saving and investment will help you build wealth.

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STEPS FOR SUCCESSFUL BUDGETING
 Budgeting your income and monitoring your behavior
will help you evaluate your spending and direct it toward
the categories that will provide you with the most value.
Four simple steps will get you on the path to financial
stability.
 Step 1. Start now as this will increase the likelihood of
success!
 Don’t fool yourself into thinking that budgeting is only for people
with jobs, or high salaries, or that you’ll start “later.”
 Step 2. Set goals.
 Use your goals to motivate your actions. Set short-, medium-, and
long-term financial goals and incorporate a plan to achieve them into
your budget.
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STEPS FOR SUCCESSFUL BUDGETING
CONTINUED…
 Step 3. Get tools to assist with your budgeting.
 Don’t recreate the wheel by starting with a blank piece of paper to
develop a budget. With today’s websites, spreadsheets, and apps,
budgeting has never been easier.

 Step 4. Devise a plan of action.

 Create a personal budget with actual and proposed items.

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“AN AFTERNOON COFFEE ANYONE?” AN
EXAMPLE OF THE POWER OF SAVING
 Many people buy a premium cup of coffee, soda, bottled
water, caffeinated drink or some other beverage each day.
Assume each drink costs $2.
 At the age of 22, stop buying a drink each day and place that $2 per
day into an investment.
 At the age of 24 bump it up by $1 and save $3 a day. Your income
will likely increase. So, it should be easy.
 At the age of 26, increase your daily savings to $4 a day.
 Do this until you are 30 years of age and you will have saved $9,490
plus interest. Pretty good.
 By the time you retire at age ­sixty-­seven, that early start can easily
add $153,305 to your wealth if invested wisely at about 7 percent a
year. (More on this expected rate of return later.) 24
COMMITMENT IS ESSENTIAL FOR
SUCCESSFUL BUDGETING.
 Dave Ramsey, one of the nation’s leading financial
advisors, highlights the importance of making a personal
commitment to forming sound money habits. He claims:
 “The thing I have discovered about working with personal
finance is that the good news is that it is not rocket science.
Personal finance is about 80 percent behavior. It is only about 20
percent head knowledge.”
 After reading Part 4, you will have the head knowledge.
Are you ready to commit to aligning your consumption,
saving, borrowing, and earning decisions with those that
promise financial stability and lead to a rewarding life?
25
MODULE 12: QUESTIONS FOR THOUGHT
1. Identify a failure oriented attitude in your life and
develop a plan for self-improvement in this area.

2. Suppose someone tells you that your attitudes are your

own business and that you should not let others change
them. Is this good advice? Why or why not?

26
MODULE 12: QUESTIONS FOR THOUGHT
3. How would entrepreneurial thinking influence your
educational choices? How would it influence your
actions as an employee?

4. Are goals important in formulating your budget?

Explain how you can use budgeting to achieve personal
goals to motivate yourself.

27
MODULE 13: SAVING AND WISE USE OF
CREDIT
 CSE Part 4, Elements 4, 5, and 6
 Concepts Covered:
 Strategicspending: used versus new
 Dangers of debt and credit card use
 Prudent saving: planning for a “rainy day”

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ELEMENT 4. DON’T FINANCE
ANYTHING FOR LONGER THAN ITS
USEFUL LIFE.

29
THE ECONOMICS OF FINANCING
 Financing makes it possible for you to buy now
and pay later.

 Financing an item over a time period lengthier

than the useful life of the asset will force you to
pay in the future for something that is no longer of
value.

 This
will increase you indebtedness and make you
poorer in the future. 30
WHEN DOES FINANCING MAKE SENSE?
 There are two major situations that justify financing.
 Long lasting assets that provide service. When a long-lasting
asset is financed and paid for before the asset is worn out,
you are merely paying for the good as you use it. Finance of
housing and automobiles provide examples.
 Assets that will yield future income. Investments are sound
when they enhance future income by an amount sufficient to
repay the borrowed funds with interest. Educational
investments often, but not always, meet this criteria.
 Rule of thumb: Do not borrow to finance anything other
than housing, automobiles, and education.

31
WHEN IS FINANCING DANGEROUS?
 It does not make sense to finance consumer non-
durables, goods that are consumed immediately or
depreciate in value quickly.
 Examples: food, clothing, vacations, nights-out-with-friends,
concerts, and tickets to ballgames.

 Borrowing for these items will lead to future payments,

reductions in wealth, frustration, bitterness, and financial
insecurity.

32
ELEMENT 5. TWO WAYS TO GET MORE
OUT OF YOUR MONEY: AVOID CREDIT-
CARD DEBT AND CONSIDER
PURCHASING USED ITEMS.

33
PRUDENT USE OF A CREDIT CARD
 Pay off the balance in full each month
 Do not buy the item if you cannot afford to pay for
it immediately.
 If you are unable to discipline yourself in this area,
cut up your credit card and use only cash.

34
PRUDENT USE OF A CREDIT CARD
CONTINUED…
 Paying with a credit card is not spending your own
money, but borrowing someone else’s if you do not pay
right away.

 Interest rates on credit cards are high because they are

unsecured. Interest rate charges will be far greater than
what you can earn on savings and investments.

 Think of your credit card as an extension of your

checking account; always pay off your credit card
balance each month.
35
IT TAKES HOW LONG?
 You buy new clothes, go to a once-in-a-life-time concert
with friends and buy more and more until you gradually
hit your credit limit of $3000 at 18%. You can only
manage to pay the minimum of $50 each month.

 How many months will it take you to pay the credit card
off?
 47,80, 100 or 155 months?
 155 months, almost 13 years!

36
YOU PAID HOW MUCH?
 You buy new clothes, go to a once-in-a-life-time concert
with friends and buy more and more until you gradually
hit your credit limit of $3,000 at 18%. You can only
manage to pay the minimum of $50 each month.
 How much does the $3,000 end up costing you in
interest?
 $360, $720, $1,300, or about $4,700?
 $4,745.35 in interest! And the items costing $3,000 are
gone, and it will take you 155 months to be rid of your
debt—so don’t do it!

37
CONSIDER BUYING USED
 Is buying new worth it?

 Depreciation costs make new cars expensive. They

depreciate substantially when driven off the lot and they
depreciate rapidly in the first three years.

 Used cars may have slightly higher maintenance costs

but their depreciation costs are much lower.

 Consider buying used! Visit Edmunds.com and compare.

38
CONSIDER BUYING USED
 Many items are just as functional used as new and often
much less expensive.

 Craigslist, eBay, and apps provide alternatives which

reduce transaction costs and make it easy to buy used
items.

39
ELEMENT 6. BEGIN PAYING INTO A
“RAINY DAY” SAVINGS ACCOUNT
EVERY MONTH.

40
RAINY DAYS AND THE REAL WORLD
 Life
is full of surprises, and they’re usually
expensive.
 Carsbreak down.
 Computers crash and smart phones die.
 Heaters and air conditioners go out.
 People get sick or injured.

41
PLAN FOR YOUR RAINY DAYS
 Put a plan in place to cover expenses that are uncertain
with regard to timing, but certain with regard to their
occurrence.

 You need a rainy day savings fund for these expenses in

your budget.
 Make contributions into your rainy day fund a mandatory part
of your monthly budget.
 You can purchase peace of mind by building a rainy day
fund.

42
MODULE 13: QUESTIONS FOR THOUGHT
1. What are the major costs of owning and operating a
car? Note: the following website will be useful:
Edmunds.com

2. What are some items that can safely be purchased with

borrowed funds? What are some items that definitely
should not be purchased with borrowed funds? Why?

3. What are the dangers involved in the use of credit

cards? How can you reduce these risks?
43
MODULE 13: QUESTIONS FOR THOUGHT
4. What is the purpose of a rainy day fund? How much
saving should you keep in your rainy day fund? Why?

44
MODULE 14: INVESTING AND BUILDING
WEALTH
 CSE Part 4, Elements 7, 8, and 9
 Concepts Covered:
 Power of compound interest
 Diversification and reducing investment risk
 Risk and return: stocks versus bonds
 Random walk theory and stock prices
 Indexed versus managed equity funds

45
ELEMENT 7. PUT THE POWER OF
COMPOUND INTEREST TO WORK FOR
YOU.

Compound interest is the most powerful force in the

universe.
—Albert Einstein

46
THE POWER OF COMPOUND INTEREST
 Save and invest regularly; there is a large payoff.

 Compound interest is simply earning interest on interest.

 If you don’t spend the interest earned on your savings this
year, the interest will add to both your savings and the
interest earned next year.
 By doing the same thing each year in the future, you then
earn interest on your interest on your interest, continuously.
 It’s like a small snowball rolling down a snow-covered
mountain.

47
COMPOUND INTEREST AND THE RULE OF
70
 The rule of 70 estimates the length of time it will
take for your money to double.
 Dividing 70 by the annual rate of return indicates the number
of years it will take for your funds to double.

 For example, if the interest rate were 5 percent, it would take

14 years for the funds to double (70 divided by 5 = 14).

48
 This exhibit illustrates the power of compound interest with a
hypothetical sixteen year-old who decides to save $7.50 per day (the
cost of a pack of cigarettes) instead of smoking.
49
 By retirement at age 67, the amount saved will grow to $1,193,512 at
a 7 percent annual interest rate!
COMPOUND INTEREST: KEY LESSONS
 In order to accumulate substantial funds for retirement,
 start early, make minor sacrifices to save regularly, know how
to get a reasonable return on your savings, and take advantage
of the power of compound interest.
 Ordinary people can have a high standard of living and
still accumulate a lot of wealth because it does not take
much savings to get a big payoff.
 As the prior exhibit illustrates, of the $1,193,512 accumulated
by not smoking, only $139,613 came from reducing
consumption.
 Over the long-term, people who save and invest will be able
to consume far more than those who do not.
50
ELEMENT 8. DIVERSIFY—DON’T PUT
ALL YOUR EGGS IN ONE BASKET.

51
STOCKS AND BONDS
 The two most common financial assets are stocks and
bonds.
 Stock: Ownership shares of a corporation. Corporations raise
funds by issuing stock ownership shares, which entitle the
owners to a proportional share of the firm’s profits. The stock
owners are not liable for the debts of the corporation beyond
their initial investment. However, there is no assurance that the
owners will receive either their initial investment or any return
in the future.

 Bond: A promise to repay the principal (amount borrowed) plus

interest at a specified time in the future. Organizations such as
corporations and governments issue bonds as a method of 52
borrowing from bondholders.
DIVERSIFICATION AND REDUCING RISK
 You can reduce your risk through diversification—
holding a large number of unrelated assets.
 Diversification puts the law of large numbers to work for
you. While some of the investments in a diversified portfolio
will do poorly, others will do extremely well. The
performance of the latter will offset that of the former, and
the rate of return will converge toward the average.

53
DIVERSIFICATION AND REDUCING RISK
CONTINUED…
 Historically, stock ownership has been a source of high
returns.
 During the last two centuries, corporate stocks yielded a real
rate of return (real means adjusted for inflation) of
approximately 7 percent per year, compared to a real rate of
return of about 3 percent for bonds.

 Mutual funds provide a low-cost method for small

investors to diversify their stock holdings.
 Equity mutual fund: An entity that pools the funds of
investors and uses them to purchase a bundle of stocks.
54
AVOID DOUBLE JEOPARDY
 Some employers offer investment programs that will
match your purchases of company stock. If you have
substantial confidence in the company, you may want to
take advantage of this offer.
 After a holding period, typically three years, you may
sell the shares of the company stock and use the
proceeds to undertake other investments. As soon as you
are permitted to do so, you should choose this option.
 Failure to sell the company stock, puts you in double
jeopardy. You would be beholden to your company both for
current employment and retirement income. If your company
fails, you would lose both.
55
ELEMENT 9. INDEXED EQUITY
MUTUAL FUNDS CAN HELP YOU BEAT
THE EXPERTS WITHOUT TAKING
EXCESSIVE RISK.

56
THE RANDOM WALK THEORY
 The random walk theory indicates:
 Current stock prices reflect the known information about a
company.
 Unforeseeable events drive changes in stock prices.
 Since future changes are driven by unforeseen events, no one
can persistently pick the winners.

 Implications of Random Walk Theory: The future

movement of stock prices will be determined by surprise
occurrences, which will cause prices to change in an
unpredictable or random fashion.
57
TWO TYPES OF EQUITY FUNDS
 Managed Equity Mutual Fund: An equity mutual fund
that has a portfolio manager who decides what stocks will
be held in the fund and when they will be bought or sold. A
research staff generally provides support for the fund
manager.
 Indexed Equity Mutual Fund: An equity mutual fund that
holds a portfolio of stocks that matches their share (or
weight) in a broad stock market index such as the S&P 500.
The overhead of these funds is usually quite low because
their expenses on stock trading and research are low. The
value of the mutual fund shares will move up and down
along with the index to which the fund is linked. 58
 INDEXED EQUITY FUNDS VS. MANAGED
FUNDS
 Managed funds: administrative costs are generally high
because of (a) the costs of employing a research staff and
(b) the costs associated with a high volume of stock
trading.
 Indexed funds: administrative costs are lower than
managed funds because (a) there are no costs of employing
a research staff and (b) the volume of stock trading is low.
 Thus, a larger share of the investor’s funds are channeled into
stock investments.
 An equity mutual fund indexed to a broad stock market
indicator such as the S&P 500 will earn approximately the
average stock market return for its shareholders. 59
INDEXED EQUITY FUNDS VS. MANAGED
FUNDS CONTINUED…
 Historically, the average long-term yield of indexed equity
funds has been higher than that of managed funds. This is
not surprising because, as the random walk theory
indicates, not even the experts will be able to forecast
consistently the future direction of stock prices with any
degree of accuracy.
 Over a typical decade, index funds tied to the S&P 500 have
yielded a higher return than 85 percent of the actively managed
funds.

 Over twenty-year periods, the index funds have outperformed

about 98 percent of the actively managed funds.
60
STOCK RETURNS AND THE LONG-RUN
 This exhibit shows the
highest and lowest
average annual returns of
the S&P 500 for various
time intervals.

 When held over a lengthy

period of time, this
diverse holding of stocks
has historically yielded
both a high and relatively
stable rate of return.
61

Source: Linqun Liu, Andrew J. Rettenmaier, and Zijun Wang, “Social Security and Market
Risk,” National Center for Policy Analysis Working Paper Number 244 (July 2001).
STOCK RETURNS AND THE LONG-RUN
 As the previous exhibit indicates, the highest and lowest
returns on stocks converge as the length of the
investment period increases.
 When a 35-year period is considered, the compound annual
rate of return for the highest 35 years between 1871 and 2015
was 9.5 percent, compared to 2.7 percent for the lowest 35
years.
 The annual real return of stocks during the worst-case
scenario was about the same as the real return for bonds.
 When held over a lengthy time period, the high and
relatively stable return of stocks makes them particularly
attractive as a retirement investment.
62
MODULE 14: QUESTIONS FOR THOUGHT
1. What is compound interest? How does compound
interest affect the importance of starting a saving and
investment program at an early age? Explain.

2. Historically, stocks have earned a higher rate of return

than bonds. What is the primary reason why this has
been the case?

3. What are the implications of the random walk theory of

stock prices with regard to the ability of “experts” to
forecast accurately the future direction of stock prices?
63
MODULE 14: QUESTIONS FOR THOUGHT
4. If Microsoft constitutes a sizeable share of your current
stock holdings, the purchase of which of the following
stocks would provide you with the greatest increase in
diversification and reduction in risk?
a) Lowe’s Home Improvement
b) Apple Computer
c) Google
d) Dell Computers

 Answer: Lowe’s

64
MODULE 15: WEALTH AND
TRANSITIONS OF LIFE
 CSE Part 4, Elements 10, 11, and 12
 Concepts Covered:
 Risk and insurance
 Risk and investments
 Portfolio adjustments and phases of life

65
ELEMENT 10. INVEST IN STOCKS FOR
LONG-RUN OBJECTIVES, BUT AS THE
NEED FOR MONEY APPROACHES,
INCREASE THE PROPORTION OF BONDS.
 Strategic Plan:
 Start saving for retirement early.
 Stay with diversified portfolios of stocks until the need for
retirement funds approaches.
 Take advantage of the favorable tax treatment provided for
retirement plans.

66
RISK ASSOCIATED WITH BONDS
 Two major types of risk accompany bonds.
1. Inflation risk: Unexpected inflation erodes the purchasing
power of the face value of the bond and the earned interest.
 Treasury Inflation Protected Securities (TIPS) help protect against
this risk.

2. Interest rate risk: Unexpected increases in the interest rate

reduce the value of outstanding bonds.
 This risk increases with the length of time to maturity.

67
SHIFT TO BONDS AS RETIREMENT
APPROACHES
 For short time periods, such as five years or less, the
return on bonds is generally less volatile than stocks.

 Transfer funds in a diversified portfolio gradually from

stocks to bonds as you approach retirement, thus
reducing your vulnerability to volatile changes in the
stock market.

68
TWO TYPES OF RETIREMENT PLANS
 There are two broad types of retirement plans: traditional
plans and Roth IRA plans.

 Traditional plans include Individual Retirement

Accounts (IRA), 401(k) plans offered by employers, and
equivalent 403(b) plans provided by non-profit
organizations.

69
TAX TREATMENT OF TRADITIONAL
RETIREMENT PLANS
 Contributions to traditional plans are deductible from
taxable income. Because of this tax saving, your after-
tax income will fall by less than your contribution.

 The contributions into the account, as well as the

earnings, are tax-deferred until they are withdrawn
during retirement.
 This will be particularly advantageous if you expect to be in a
lower tax bracket during your retirement years.

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TAX TREATMENT OF ROTH IRAS
 Contributions into a Roth IRA are not tax deductible.
Thus, there is no tax advantage at the time the
contributions are made.

 However, the value of your investments grow tax-free

and during your retirement years, both the contributions
and investment earnings of a Roth IRA can be withdrawn
without any payment of taxes.

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TRADITIONAL VS. ROTH PLANS
 A traditional retirement plan will generally be a better
option if you believe your current tax rate is higher than
it is likely to be during your retirement years.
 In contrast, a Roth IRA will probably be better for you if
you believe your current marginal income tax rate is
about the same or lower than what you expect it to be
when you are making withdrawals during retirement.
 Factors other than present and future income can also be
important. Therefore, you should seek some impartial
and expert advice before making a decision.

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ELEMENT 11. TAKE STEPS THAT WILL
REDUCE RISK WHEN MAKING
HOUSING, EDUCATION, AND OTHER
INVESTMENT DECISIONS.

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PURCHASING A HOME: PITFALLS TO
AVOID
 The purchase of a home is one of the most important
investment decisions most of us will confront.
 Pitfalls to avoid when purchasing a home:
 Renting versus ownership: There is a tendency to believe
that when you are purchasing a home your monthly mortgage
payment will build equity. However, during the first few
years, almost all of your monthly mortgage payment will
merely cover interest charges. Your outstanding debt will be
reduced by only a small amount. You are simply paying the
bank interest instead of paying rent to a landlord.

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PURCHASING A HOME: PITFALLS TO
AVOID CONTINUED…
 Expected length of tenure: Buying and selling real estate is
expensive and therefore it is not a good idea to purchase a
house unless you expect to live in it at least three years.

 Down payment: Do not buy a house until you have saved for
a sizeable down payment, preferably at least 20 percent. If
your down payment is less than 20 percent, you will have to
pay mortgage insurance, which increases your monthly
payment.

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PURCHASING A HOME: PITFALLS TO
AVOID CONTINUED…
 Maintenance and other costs: Just because you can afford a
mortgage payment doesn’t mean you can afford the house. In
addition to the mortgage payment, home owners will also
incur property taxes, insurance, maintenance, and other
expenses. Do not forget these costs!

 Eroding your equity: As you build up equity in your house,

do not take out another mortgage or borrow against your
equity in order to increase your current consumption.

 The above guidelines will encourage you to live within

your means, economize on housing, and minimize the
risks involved in housing decisions. 76
EDUCATION: PITFALLS TO AVOID
 Pitfalls to avoid when investing in education.
 College is not for everyone. Going to college is expensive,
particularly when the earnings foregone are considered.
Going to college for a couple of years and then dropping out
is often a bad investment.
 It is risky to borrow large amounts for the finance of
education leading to low wage occupations. For information
on earnings in various occupations, consult resources like
PayScale.com and the BLS Occupational Outlook Handbook.
 Students overuse debt. Some view the student loan check as
free money and borrow too much. Many young people are ill-
prepared to judge how difficult it will be to squeeze the funds
for repayment of student loans out of their monthly budget 77
after graduation.
INVESTMENT PITFALLS TO AVOID
 It is important to recognize that when making
investments, you are vulnerable; you need to
think about whether your interests are aligned
with the party offering the investment.
 Whenever you are offered something that
seems to be an extremely attractive
proposition, it pays to step back and carefully
examine the incentives behind why this
proposition is being presented to you.
 Beware of deals that sound too good to be
true!

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TIPS FOR AVOIDING INVESTMENT
FRAUD
 If it looks too good to be true, it probably is.
 Deal only with parties that have a reputation to protect.

 Never purchase an investment solicited by telephone or

email.
 Do not allow yourself to be forced into a quick decision.

 Do not allow friendship to influence an investment

decision.
 If high-pressure marketing is involved, grab your
checkbook or debit card and run!

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ELEMENT 12. USE INSURANCE TO HELP
MANAGE RISK.

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MANAGING RISK
 Life involves risks. You cannot eliminate risk, but you
can take steps to reduce and manage it.

 Insurance can reduce the financial loss resulting from

damages to possessions (such as your home or car), an
illness, loss of income, or other harmful events.

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WHAT IS INSURANCE?
 Insurance provides a way for a group of people to pool
payments and share risks in order to offset the losses of
members actually damaged by an adverse event.

 The principle of sharing risk is often forgotten because

individuals pay premiums to an insurance company and
have no interaction with the group members.
 The insurance company collects premiums from each
member of the group (its policyholders), then disburses
payments when a covered loss occurs.

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WHAT IS INSURANCE? CONTINUED…
 In addition to the cost of covering the pooled risks, the
insurer will also incur marketing, administrative, and
handling costs. Thus, the insurance premiums will have
to be somewhat higher than the expected costs of the
losses of policyholders.
 Insurance reduces risk because it spreads the burden of
unfortunate events that a few experience over a larger
group of people.
 When it comes to large sums, most of us are risk-averse.
Thus, we are willing to pay a premium in order to reduce
the adverse consequences of various events.
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INSURANCE IS NOT ALWAYS COST-
EFFECTIVE
 It will make sense to insure against events that, if they
occur, will impose severe financial hardship. Examples
include: a severe illness that prevents you from working
for an extended period of time, a car accident, or a flood
that damages your home.
 However, insuring against relatively small adverse events
such as a breakdown of an appliance or television is
generally not cost-effective. Providing the risk-sharing
service will be expensive relative to the potential harm.
Thus, it will generally be more economical to accept
these risks and use your rainy day fund to plan for and
cover their costs. 84
SOME KEY INSURANCE TERMS
 Alternative Types of Automobile Insurance
 Collision coverage: pays for damages to your car in the
event of an accident.
 Comprehensive coverage: pays for non-collision damages
such as theft, vandalism, and acts of nature like a tree branch
falling on your windshield.
 Liability coverage: comes in two forms.
1. It pays others for damages to their person or vehicle caused by the
operation of your automobile.
2. It pays damages to you and your passengers for medical expenses
and death benefits.

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SOME KEY INSURANCE TERMS
 Additional Insurance Terms
 Deductibility: The amount the policy holder must pay before
the insurance coverage begins. For example, if the deductible
for a homeowner or auto insurance policy was $500, the
insured would be responsible for the first $500 of damage.
 Co-payment: An upfront fee the insured must pay for a
service. For example, a $20 co-pay for a doctor visit or
prescription.
 Co-insurance: The percent share of the cost of an adverse
event that the policy holder must pay. For example, a health
insurance policy may require the customer to pay 20 percent
of the bill for a hospital stay or medical procedure.
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CONCLUSION: TEACHING YOUR
CHILDREN PRINCIPLES OF SUCCESS
 Money is earned by providing services others value.
 Instead of an allowance, pay your children for performing
certain tasks and educational successes.
 Money spent on one thing means less funds available for
the purchase of other items or savings and investing.
 Beginning at an early age, teach children about this reality
and provide them with experiences that will help them learn
to choose wisely.
 Money both helps us get what we want, and helps others
get what they want.

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CONCLUSION: KEY INGREDIENTS FOR
YOUR SUCCESS
 To a large degree success in life is about setting goals,
working hard to achieve them, figuring out how to make
your services useful to others, saving for a specific
purpose, and spending money wisely.

 We are now at the end of a journey. Our goal has been to

provide you with information and tools that will help
you live a more successful and fulfilling life. It is our
hope that today you will start on a new journey–that you
will earnestly resolve to take control of your life and
choose options more consistent with success.
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MODULE 15: QUESTIONS FOR THOUGHT
1. What is the difference in the tax treatment of a
traditional retirement plan and a Roth IRA? If you are
currently in a high tax bracket and expect to confront a
lower marginal tax rate during your retirement years,
which of these two options would be most attractive?
Explain.

2. Why is the default rate on student loans so high? What

are some of the pitfalls one should avoid when
considering borrowing funds to finance schooling?

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MODULE 15: QUESTIONS FOR THOUGHT
3. When does it make sense to purchase insurance? Under
what circumstances is insurance likely to be a poor
investment?

4. People tend to appreciate things they earn more than

things that are given to them. Do you think this is true?
How might this impact how parents should deal with
their children?

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