1 Introduction to Personal Financial Planning

Why Should You Care About Personal Financial Planning?

“A man who does not plan long ahead will find trouble at his door” ~ Confucius

Life as a student can be stressful. You have to meet academic demands, manage social relationships, and plan for your careers. Financial concerns add to these stresses. Research has shown that financial stress is a pervasive issue among students. A survey of about 30,000 undergraduate students found that 74 percent of respondents agreed or strongly agreed that they were stressed out about their personal finances.^[1] This financial strain can have a profound impact on mental health. Many studies have shown that financial stress was associated with depression.^[2] The negative impact was more pronounced among vulnerable groups such as unmarried individuals, the unemployed, lower-income households, and renters.^[3] The detrimental effects of financial stress extend beyond mental health, impacting personal relationships as well. Financial disagreements were the strongest predictor of divorce, highlighting the strain that financial instability can place on partnerships.^[4]

Effective financial planning can play a crucial role in mitigating these negative outcomes. By making informed financial decisions and developing sound financial habits, you can reduce financial worries and build a more secure foundation for your future, fostering healthier relationships and overall well-being.

Personal Financial Advice in the Popular Culture

The demand for financial advice is substantial, as shown by the multitude of platforms dedicated to the topic, including podcasts, blogs, videos, websites, books, TV shows, and internet forums. The Schwab Modern Wealth Survey of 2024 found that 38 percent of Gen Zers receive financial information or advice from YouTube, while 33 percent turn to TikTok. However, the quality of these resources is highly variable, and for those without prior knowledge, it can be challenging to discern reliable information from misleading or inaccurate advice.

Even though popular financial advice frequently diverges from economic theories, these recommendations consistently gain traction among consumers.^[5] Their popularity is due to their simplicity, alignment with real-world constraints, and consideration of human behavioral tendencies. Unfortunately, some of these recommendations may not be financially optimal or applicable to individuals who do not fit the mold of the middle-income mainstream American household.

This book aims to debunk common financial myths and leverage economic theories where applicable, empowering you to become a well-informed consumer of financial advice. By critically evaluating financial information and understanding the underlying economic principles, you can make sound financial decisions that are tailored to your individual circumstances and goals. Remember that financial advice should be personalized and consider your unique situation, rather than relying solely on generic recommendations that may not be suitable for everyone.

How Much Do You Know Now?

Concern about America’s lack of financial literacy has made headlines year after year. The latest result from the personal finance index survey showed that respondents answered only 48 percent of the questions correctly in 2024.^[6] For the past 8 years, this score has hovered around 50 percent, a failing grade. The findings are even more troubling for women, minorities, and the younger generations (Figure 1.1). Financial literacy among women has consistently lagged that of men with a 10-point gender gap in 2024. Scores for White and Asian Americans averaged in the mid-50s while those for Blacks and Hispanics were in the mid-30s, a 20-point gap. Financial wisdom did improve slightly with age. There was a 9-point gap between Boomers and Millennials (Gen Y), and a 17-point gap between Boomers and Gen Zers.

The above findings are not unique. Another study examined racial and ethnic disparities in financial literacy using a 5-question quiz and found that Blacks and Hispanics tended to score substantially lower than Whites after controlling for income levels.^[7] For the low income group with annual income less than $40,000, Blacks and Hispanics scored 1.615 and 1.862 respectively, meaning these groups answered less than 2 questions correctly on average. White respondents averaged 2.709 in the same income group, significantly higher. Scores were higher for higher income groups but the disparity between racial groups persisted.

Financial stress has negative consequences for both health and personal relationships. Although financial knowledge alone is not sufficient to mitigate this stress, it is essential. Financial literacy should be a universal right, independent of wealth, income, gender, or race. My motivation for writing a personal finance book as an open educational resource is to remove obstacles to achieving financial literacy. You may be curious about your current financial knowledge compared to participants in this study. Take the following 5-question quiz to find out for yourself.

Wealth and Income Gaps in the U.S.

While it may appear logical for higher income earners to be more financially literate, it also creates a vicious cycle – lower income earners make poorer financial decisions, leading to more financial stress, resulting in even less wealth accumulation. How severe is income and wealth inequality in the United States? The St. Louis Fed’s Institute for Economic Equity provides quarterly data on racial, generational and educational wealth inequality based on average U.S. household wealth. Below are results for the second quarter of 2024.^[8]

• Wealth gap by household education
  • Families headed by someone with a four-year degree had 3 times more wealth than families headed by someone with just some college education (but no four-year degree).
  • Families headed by someone with a four-year degree had 4 times more wealth than families headed by someone with a high school diploma.
  • Families headed by someone with a four-year degree had 10 times more wealth than families headed by someone with less than a high school diploma.
• Racial wealth gap
  • Black families owned about 23 cents for every $1 of white family wealth on average. Hispanic families owned about 19 cents for every $1 of white family wealth on average. In other words, white families were 4 times wealthier than black families and 5 times wealthier than Hispanic families on average.
• Generational wealth gap
  • Millennials and Gen Zers had 30 percent more wealth than Gen Xers and baby boomers did at the same age.

• Overall wealth gap (See Figure 1.2)
  • The wealthiest 10 percent of households held an average of $6.9 million per household in wealth and accounted for 67 percent of the total household wealth. In contrast, the bottom 50 percent of households only had $51,000 on average and represented a mere 2.5 percent of the total household wealth. In other words, the top 50 percent of households owned 97.5 percent of total wealth.

The degree of inequality has increased in the United States since the 1970s.^[9] Why should we care about wealth inequality? Multiple studies found that wealth inequality is associated with reduced economic growth.^[10] In other words, this trend of widening wealth inequality harms us all. Tackling structural income and wealth inequality is beyond the scope of this book. However, you will learn important tools to help you improve your own financial situation and start building wealth, no matter where you are today.

Factors to Consider When Creating Your Financial Plan

Many existing financial planning textbooks and advice assume a traditional household with two parents, two kids, middle to upper-middle income, and above median wealth. This is not surprising since most professional financial advisors earn their fees as a percentage of money they manage. The needs of those not fitting into the traditional mode are seldom discussed. In this book we will address the diverse financial planning issues of an inclusive demographic.

Age, income, occupation, household size, and number of dependents are important factors to consider when developing your financial plan. In a traditional adult life cycle, many of these factors follow a familiar pattern.

Many of us do not fall into this traditional life cycle. Some of us have to help support our family in our early adulthood. Others have grown children or parents living with them throughout their lives. Still more people do not have sufficient retirement savings to stop working after age 67. Instead of focusing on these milestones, a more useful approach is to focus on your own values.

Take homeownership as an example. According to the Organization for Economic Co-operation and Development (OECD) Affordable Housing Database from 2022 (Figure 1.3) , the percentage of homeownership varied greatly by country. In the United States, over 60 percent of people owned their own homes but less than 30 percent owned them outright. In contrast, over 60 percent of Italians owned their homes outright and overall homeownership exceeded 70 percent in Italy. In Germany, less than 30 percent of Germans owned their homes outright and almost 60 percent of Germans rented their residences. The importance of owning your own home depends on your personal values and affects how you prioritize it in your financial plan. In some cultures, homeownership can affect many aspects of your life. According to a survey on the post-1990 generation entering marriageable age in China, two-thirds believed that a house is necessary for marriage and rising housing prices had a negative impact on the marriage rate.^[11] In America, homeownership is an essential element of the American dream. In a later chapter we will discuss in detail the economic advantages and disadvantages of owning a house. For now, take a moment to reflect on how you feel about homeownership. Does your family of origin affect your view on this issue? Do you believe owning a house is achievable and want to include it in your financial plan? Or do you feel that it is inaccessible? There are no wrong answers. Know that many people face the same challenges and worries.

The essential factors to take into account in your financial plan include: age, your relationship status, number of people living in your household, number of people dependent on you for financial support, and your career. According to research, the most common financial planning mistakes include:

• Unrealistic expectations.
• Emotional decision making.
• Inflexibility.
• Inaction.
• Unclear values and priorities.

The next section lays out a step by step guide to create your financial plan and strategies to avoid these common mistakes.

Steps to Develop a Financial Plan

Personal financial planning is simply a step-by-step process to manage your spending, borrowing, and investing to improve your financial situation. Most importantly it is an iterative process, meaning you need to repeat it on a regular basis.

Step 1: Establish Your Financial Goals

Elements of a SMART Goal

SMART goals are specific (S), measurable (M), achievable (A), relevant (R), and time-bound (T). Stating your financial goals in this format will make implementing, evaluating and making necessary adjustments to your financial plan much easier.

Start by reflecting on your personal values and life goals. Some examples of personal values include security, independence, knowledge, responsibility. Your life goals should reflect your personal values. Remember to be true to yourself. What is desirable for one person may not be appropriate for you. Take two extreme potential life goals. Some people view their profession as their life mission and retirement is simply not one of their life goals. Instead their goal is continuous contribution to their profession. At the other end of the spectrum are people who value financial independence so much that they join the Financial Independence, Retire Early (FIRE) movement, which is defined by frugality and extreme savings. Most people fall somewhere between these two extremes and would like to retire in their sixties, when they can start to receive Social Security benefits and Medicare insurance coverage. Your personal values may inspire you to contribute to specific causes. Whether consciously or subconsciously, your lifestyle is driven by your personal values. You may want a vacation every year, a grand wedding, or a ten-bedroom house. You may want to have children, with or without a partner. You may want to volunteer full time to charity work. It takes money to support these goals. Financial goals are simply the amount of money needed for each of your life goals. Therefore, they should be relevant (related to your life goals and values) and specific (a concrete dollar amount).

Timing of Goals

Financial goals can be characterized as short-term (over the next 6 to 12 months), intermediate-term (between two to five years), or long-term (beyond 5 years). For example, a short-term goal may be to put away enough money to establish an emergency fund within the next 6 months. An intermediate-term goal may be to save enough money to purchase a car in three years. A long-term goal may be to save and invest for a house down payment in eight years. Another very common long-term goal is to save for retirement. Remember that setting a specific time is an important element of a SMART goal.

Set Achievable Goals

Your financial goals should be realistic, meaning you have a reasonable chance of achieving them. Whether a goal is realistic depends on your financial situation, your personal situation, your values and personality. Setting unrealistic goals will lead to disappointment and a sense of failure. Instead of improving your well-being, unrealistic goals can add to your stress. For example, you are intrigued by the FIRE movement and are considering retirement by age 35. To do so will require you to rent out rooms in your house, forgo all entertainment and non-essential purchases, and take on a second job, leaving no time to spend with your family and friends. Given how important time with family is for you, you will not be able to follow such a plan for very long because it will harm, rather than improve, your personal relationships. Instead, a goal to retire by age 50 may be much more achievable.

Step 2: Assess Your Current Financial Position

Maya Angelou said, “You can’t really know where you’re going until you know where you have been.” Therefore, the next step when developing a financial plan is to review your past spending and saving patterns as well as your current debt and assets positions. Chapter Three focuses on personal budgeting. It is useful to identify elements in your budget that you can control versus those you cannot. How much you can spend and save obviously depends on how much income you earn. For most of us, our main source of income is through our job. Therefore, choosing a career is an important part of your financial plan. We will explore different careers, employment opportunities, and education in Chapter Two.

Your financial position includes both debts and assets. While debt values do not change (except for when we pay them off), the value of assets vary depending on the economy and condition of the assets. Therefore, your financial position will change with the economy. Take house prices as an example. In the United States, though house prices increase in the long run, they can decrease sharply during economic downturns (Figure 1.4). During the 2008 financial crisis, median house price dropped almost $50,000, approximately 20 percent, between 2007 and 2009.  In an earlier section of this chapter, we learn that the majority of American homeowners have mortgages. When the mortgage amount is greater than the value of the house, the homeowners are considered “under water.” This happens when house prices drop greatly. A survey found that the percentage of housing units under water doubled from 8 percent in 2007 to over 16 percent in 2009.^[12] On the other hand, median house price increased by over $100,000, over 33 percent, between 2020 and 2023. You need to consider how different economic conditions will impact your financial position in the future. You cannot control the economy but a sound financial plan can prepare you to weather tough economic times.

Step 3: Identify and Rank Alternative Plans

Once you have established your financial goals and have a clear understanding of your current financial situation, you can determine the necessary steps to achieve those goals. Sometimes, no action is required. For instance, if your estimated monthly budgeted expense is $2,000 and you aim to have a 6-month emergency fund, you would need $12,000 (6 months x $2,000 per month). If you already have $15,000 in your savings account, you have exceeded your short-term goal, and no further action is needed.

However, it is uncommon to have enough cash to purchase everything outright. Many people need to borrow money for large purchases like a car or a house. They also need protection against losing these assets in case of accidents or natural disasters. To reduce financial stress, saving for emergencies and retirement is crucial.

A good comprehensive financial plan will enable you to maintain your desired lifestyle, achieve your life goals, and have adequate protection against uncertainties in life and the economy. This plan should include strategies for debt management, investment, insurance, retirement planning, and estate planning.

Elements of a Financial Plan

• Budgeting (Chapter 3)
• Tax planning (Chapter 4)
• Managing your credits (Chapter 6)
• Managing your day-to-day cash flows (Chapter 7)
• Financing major purchases such as auto loans and student loans (Chapter 8)
• Purchasing a house with a mortgage (Chapter 9)
• Investing your money (Chapter 10)
• Retirement planning, estate planning, and protecting your dependents (Chapter 11)

We will discuss how to develop each of these elements in detail in future chapters. When developing each element, the multitude of choices can feel overwhelming. This is a common response. Psychologists refer to this condition as decision paralysis. To overcome this, it is crucial to rank alternatives based on their feasibility and alignment with your personal values and lifestyle. Let us look at an example to illustrate this process.

Jordan’s decision-making process demonstrates how personal values and lifestyle can guide financial choices. By prioritizing their values and considering their lifestyle, Jordan can navigate the complexities of car buying and make informed decisions that align with their overall financial goals.

To assess an alternative’s feasibility, you examine how it affects your budget. Let us look at the car purchase example again.

Remember that financial planning is an ongoing process that requires flexibility and adaptability. It is common to realize during the initial stages of planning that some of your financial goals may not be achievable based on your current financial situation. This is not a sign of failure, but rather a normal part of the financial planning process. It is important to be willing to revise and adjust your financial goals as needed.

There will likely be times when you will need to make trade-offs between different goals. For instance, in the car purchase example mentioned earlier, Jordan might decide to purchase the 5-year-old car instead of the new one. This decision would allow them to maintain their goal of saving enough for a down payment on a house in 6 years without having to make significant changes to their lifestyle. Alternatively, Jordan could choose to buy the new car and delay their home purchase by a couple of years.

The extent of the revisions needed will vary depending on individual circumstances. Some people may only need to make minor adjustments to their financial plan, while others may discover that they need to make major changes to achieve their goals. Regardless of the extent of the revisions, the act of creating a financial plan is a crucial step towards turning your dreams into reality. It provides you with a concrete roadmap and actionable steps, rather than leaving your goals as mere aspirations.

Step 4: Select and Implement the Best Plan

Now that you have a financial plan, you need to take the necessary steps to put it into action. However, making changes and sticking to them can be challenging. Research  has shown that a significant percentage of people fail to keep their New Year’s resolutions. Financial goals are no exception.^[13]

Implementing a financial plan often requires changes in behavior and habits, which can be difficult to maintain. It is common to encounter obstacles and setbacks along the way. This is where insights from psychology can be valuable. Psychologists who study human behavior and decision-making have identified strategies that can help you successfully implement and follow through with your financial plan.

Psychology and Money

A good place to start is to explore your own money beliefs. Psychologists have examined four attitudes towards money: avoidance, worship, status, vigilance.^[14] Knowing your attitudes toward money will help you predict which part of implementing the financial plan will be challenging for you and develop strategies to overcome them.

Money avoiders associate fear with money, feel anxious about it, and worry about overspending or financial risks. They tend to be younger, with lower incomes and wealth. While caution is good, avoiding financial planning can make them less prepared for the future. It will take more effort for money avoiders to assess their financial positions because checking on their account balances may be a stressful activity. They may delay retirement planning until it is too late because they do not want to think about anything related to money.

Money worship is the belief that more money will solve all problems. Similar to money avoiders, many people within this category have lower than average income levels and wealth. They are much more likely to accumulate debt by overspending. If you identify with this, consider what truly makes you happy in the long run instead of engaging in “shopping therapy”. Sticking to a budget may be challenging for individuals who have poor spending habits.

Individuals possessing a money status personality perceive money as a symbol of their personal worth and accomplishments. This mindset often leads to excessive spending and a propensity for high-risk financial behaviors. While financial security undoubtedly provides opportunities and enhances one’s quality of life, an unhealthy preoccupation with financial success can have detrimental effects on overall well-being. This is particularly true when individuals engage in risky financial behaviors driven by the desire for rapid wealth accumulation. Following a disciplined investment strategy and avoiding get rich quick schemes like day-trading or cryptocurrencies would be the key to success or failure.

Money vigilance describes individuals who are secretive about their finances and distrustful of common financial management methods. These individuals may be hesitant to share financial information with even their spouse. They avoid overspending and are wary of taking on debt. While saving is generally positive, excessive money vigilance can have drawbacks, such as lower returns by not investing their money and lower credit score by not using any credit card. Financial knowledge may help this group distinguish financial facts from myths and gain confidence in taking on necessary risk so they can achieve their financial goals.

People do not fall exclusively into one category. We are likely to have multiple traits. These false money beliefs serve as useful guideposts to help you identify pitfalls, especially in spending habits.

Let us look at some financial decisions that Jordan and their identical twin, Chris, made in the past few years since high school. Unfortunately, Jordan and Chris did not have good role models for financial planning. Their parents had poor spending habits and were always in debt, even declaring personal bankruptcy once. But the family had lots of fun on their luxury vacations and lavish holiday gifts.

Strategies to Overcome Psychological Barriers

When faced with a multitude of tasks, especially those that are unfamiliar or complex, it is not uncommon to experience a sense of overwhelm. This can lead to task paralysis, a situation where the perceived enormity of the tasks ahead makes it difficult to take action. This inaction is often attributed to the “freeze” response, a psychological reaction to perceived threats.

To overcome this inertia and begin making progress, it is helpful to break down large tasks into smaller, more manageable steps. For example, one of your short-term goals is to have $12,000 in an emergency fund in 6 months. You currently have $8,000 in the bank. To reach this goal, you need to save another $4,000, which may seem daunting. You can break this goal down to $25 per day. This strategy of combining smaller goals with larger goals has been shown to increase the likelihood of success.^[15] Additionally, starting with the easiest or smallest task can help build momentum and confidence, making it easier to tackle more challenging tasks later on.

It is also important to be mindful of planning fallacies, which occur when we underestimate the time and effort required to complete a task. By incorporating buffer time into your plans and being realistic about your capabilities, you can avoid setbacks and stay on track. Remember, progress is often made in small increments. By breaking down your goals, celebrating small wins, and being mindful of potential pitfalls, you can overcome task paralysis and achieve your financial objectives.

By incorporating these strategies and seeking guidance from experts when needed, you can increase your chances of successfully implementing your financial plan and achieving your financial goals. Remember, it is a journey, not a destination. Be patient with yourself, stay committed, and celebrate your progress along the way.

Step 5: Evaluate the Progress of the Chosen Plan

This is the moment when the rubber meets the road. There are many reasons why a financial plan may not be progressing as intended. These can be broadly categorized into factors beyond your control and those within your control.

Factors beyond your control, such as the economy and personal health, can significantly impact your financial plan. For instance, the investments are not earning the predicted returns due to an unexpected downturn in the economy. At the same time the housing and mortgage market may have cooled down, reducing your house payments and property taxes.

There are also factors that are within your control but where you may not have taken the necessary actions. For example, you had budgeted to save $200 per week. You went out to a fancy restaurant for a first date and impulsively purchased a new outfit for the occasion. Instead of saving $200, you end up with a $150 balance on your credit card.

To ensure your financial plan stays on track, periodic reviews are essential. The frequency of these reviews may vary depending on the specific element of the plan. Your budget should ideally be monitored monthly to allow for timely adjustments, while investment results can be reviewed quarterly or semi-annually. Other aspects of your financial plan, such as tax planning, retirement planning, estate planning, and insurance coverage, can typically be reviewed annually. Pick a time that is easy for you to remember, such as your birthday, end of the year, or when you prepare your tax return. Evaluating your financial plan during tax preparation has the advantage that you have already collected much of the financial data.

Step 6: Revise your Financial Goals and Plan

You should review and update your financial goals annually or when a significant life event happens. Examples of significant life events include marriage, divorce, birth or adoption of a child, job changes, and retirement. You may also need to revise your financial goals to make them more achievable if you find that your financial plan is not progressing as expected in step 5. As time passes your financial position will change and you may want to change your financial goals. After updating your financial goals, repeat steps 2, 3, and 4 to revise each element of your financial plan.

Regular review and adjustment of your financial plan are essential to stay on track and adapt to changing circumstances. Remember, financial planning is a dynamic process. Your goals, income, expenses, and risk tolerance may change over time. By proactively managing your finances and seeking professional guidance when needed, you can build a secure financial future and achieve your long-term aspirations.