What is personal finance? Definition and examples
The term personal finance is all about how we, as individuals or families and not companies or organizations, manage our money, save, and invest. It is the financial management each person performs to spend, budget, save, and plan for retirement and other the future events.
Personal finance may refer to the whole area from the individual’s point of view or that of the sector that provides individuals and families with financial services.
Investopedia.com has the following definition of the term:
“Personal finance is a term that covers managing your money as well as saving and investing. It encompasses budgeting, banking, insurance, mortgages, investments, retirement planning, and tax and estate planning.”
Personal finance – five main areas
Let’s look at the five main areas of personal finance: 1. Income. 2. Budgeting (spending). 3. Saving. 4. Investing. 5. Protection:
Our income is money that we receive and then use to buy things, support our loved ones, pay bills, save, and invest. Salaries, hourly wages, commissions, pensions, gifts, dividends, government payouts, and bonuses are examples of some sources of income.
In one of our previous articles, we defined income as follows:
“Income refers to money – cash or cash-equivalents – coming in either for work done, interest or profit from capital invested, or rent from a property or land that is let. When it comes from work it is referred to as either a wage or a salary.”
Spending is the opposite of income. It is the money that leaves us. Examples include paying bills, rent, mortgage, paying for a round of drinks with friends, shopping, filling our cars, buying presents, and making donations to charity. Our credit card and tax payments also come under the term spending.
We either spend with money we have or money we borrow, i.e., credit. Spending represents a major portion of most people’s income. When you spend more than you earn, you might eventually find yourself in financial difficulties.
Famous author Charles Dickens (1812-1870) wrote the following in his book David Copperfield:
“Annual income twenty pounds, annual expenditure nineteen and six, result happiness. Annual income twenty pounds, annual expenditure twenty pounds ought and six, result misery.” (six means six pennies. At that time, there were 240 pennies in one pound)
Do not underestimate the importance of managing spending. It is just as crucial, and maybe even more so, than generating income.
If your income is greater than your spending, you have a surplus. This is money you can save. Economists sometimes refer to savings as deferred consumption. There are many ways to save money.
If you don’t like or trust banks and other financial institutions, you could keep the money as cash. There is an the old saying: “He keeps his money under the mattress.”
Most people have a savings bank account, which is referred to as a deposit account in some parts of the world. You might also make payments into a pension account.
If too many people save too much, the national economy can suffer. Japan’s economy suffered from extremely weak growth for nearly two decades because consumers were not spending enough – they were saving too much. If people don’t spend, businesses suffer.
If you are not happy with the returns that your savings bank account gives you, you should consider investing. You could purchase some assets such as stocks (shares) and hope that you will eventually get a better return than you would elsewhere.
Where you invest depends on whether you are risk-averse or risk-seeking. A risk-averse investor does not like taking big risks, while a risk-seeking one is looking for a greater return, even if it means more risk.
Apart from stocks, you might also consider investing in real estate, mutual funds, bonds, or commodities. If you have enough money, you could even invest in somebody’s startup business if you like their idea, i.e., become an angel investor.
The Corporate Finance Institute makes the following comment regarding investing from a personal finance point of view:
“Investing is the most complicated area of personal finance and is one of the areas where people get the most professional advice. There are vast differences in risk and reward between different investments, and most people seek help with this area of their financial plan.”
Protection, in the world of personal finance, refers to guarding against adverse or unforeseen events and protecting the financial interests of your loved ones.
Examples include house insurance, car insurance, income insurance, and home contents insurance cover. They will protect you should anything happen to your home, job, furniture, etc., or your car.
If you live in a country that does not have free universal health care, you should seriously consider taking out a health insurance policy.
When you die, what will happen to your money and other possessions? Do you have a will? A will or a last will and testament is a document in which you state where your money and other assets should go after you die. It lists who the beneficiaries should be.
Make sure you execute your will properly. If you don’t, it might be invalid. You won’t know (because you will be dead), but your loved ones will.
Personal finance – what to do
For many people, trying to secure their lives financially may feel like an overwhelming or daunting task. One that requires a level of expertise that they do not have.
Do not despair, you are not alone. For a start, set out some simple goals. Try to identify where you are now and where you expect to or would like to be in five or ten years’ time.
Calculate whether you have a monthly surplus or deficit. In other words, is your monthly income greater or small than your expenditure. When you have done that, you have created a plan and a budget.
For your next steps you have two choices:
Do your research
Spend about one month reading as much as you can about personal finance. There are thousands of interesting and useful articles and videos online. Then, see if you are in a better position to start creating a financially secure life.
Get professional help. There are many financial advisers who could help you get started. Make sure that the one you choose is qualified. You could ask your bank whether they have a personal finance advice service. However, their person is probably a tied adviser; they will only give you advice on their bank’s products. Independent financial advisers have access to a much wider range of financial products.