Personal Finance
Components of a Financial Plan
February 12, 2025
In this entire module on personal finance, we have written several articles on steps that need to be taken to ensure that a person has a good future. However, in the field of personal finance, it is almost as important to not do certain things as it is to do certain others. Financial mistakes can be very expensive. They can set people back by decades if not a few years. This is the reason why in this article, we will discuss some of the mistakes that diligent investors should advise at all costs.
- Futures and Options: Most personal financial planners advise their clients to invest in the market. However, they do advise them to invest in the long run. In the short run, stocks have high volatility and risk. However, if the investment horizon is increased to more than a decade, the risk reduces sharply.
The problem with futures and options is that even though the investment happens in equity or commodity assets, these instruments make it virtually impossible to invest for the long term.
Most futures and options contracts have an expiration date. Hence, they are speculative by their very definition. Also, futures and options contracts are traded with high leverage. Hence, an investor may be involved in a contract wherein their position is several times larger than their net worth! It is for this reason that futures and options shall be avoided at all costs. They have the potential to cause large scale damage to the portfolio of an individual.
- Short Selling: Short selling is a smaller and less risker version of futures and options. Most financial planners would advise their clients to avoid short selling as much as possible. This is once again because short selling involves short term positions. The leverage involved may not be as high. However, a short position needs to be covered within a few days. Hence, there is no question of long term investing with a short position.
- Buying Housing With No Money Down: The earlier generation was of the opinion that investing money in stocks and mutual funds is risky. However, at the same time, investing in houses is safe. This is why the term “as safe as a house” was coined. However, we now know that is not really true. The subprime mortgage crisis was the result of a lot of people making bad investments in the housing market.
Generally, a house should be purchased only with a significant amount of money down and with a traditional interest rate (fixed or variable). If the purchase is being made with zero money down or an artificially low teaser rate or an interest-only loan, then this can also be classified as speculative.
Houses are generally very expensive. They cost at least three to four times the income of an average person. Hence, if a person makes a speculative deal on a house and ends up losing money, they could end up losing a huge chunk of their net worth.
- Paying High Transaction Costs: In the short run, transaction costs of a couple of percentage points may not seem to be much. However, with the effect of compounding, a small difference of 2% to 3% in the compounded annual growth rate can reduce the amount of the corpus by as much as 30%! In the short run, transaction costs may not feel like much of a talking point. However, many investors have realized that the difference that they create can be huge.
- Always Being in Debt: There are several people in American and even in the world, who believe that always staying in debt is the normal way to live. It is important to break this belief and get out of debt as soon as possible. The ability to get out of debt and to stay debt-free has been ranked as one of the biggest indicators of financial success.
- Upgrading Your Lifestyle With Every Pay Raise: The main reason why people stay in debt is that they start to upgrade their lives every time they get a pay raise. They often want a bigger home, a bigger car, and a more expensive education for their kids.
It is important to realize that when we receive a raise, we must first try to increase our savings instead of trying to raise the expenses. The goal should be to create assets which then further create income.
- Living Paycheck to Paycheck: Lastly, the vast majority of Americans are living paycheck to paycheck. This should send an alarm bell ringing. This is because if people keep living paycheck to paycheck sooner or later, something will go wrong and that time the person will not have any money to face adversity. Living like this should not be considered an acceptable life choice and people should consider it an emergency situation and make frantic attempts to better their current financial position.
The bottom line in personal finance is always the same. The subject may appear to be based on mathematics, however in reality it is based on behavioral sciences. Hence, people should avoid certain types of negative behaviors if they don’t want to jeopardize their own financial position.