Personal finance is the process of planning and managing personal financial activities such as income generation, spending, saving, investing, and protection. The process of managing one’s personal finances can be summarized in a budget or financial plan. This guide will analyze the most common and important aspects of individual financial management.
In this guide, we are going to focus on breaking down the most important areas of personal finance and explore each of them in more detail so you have a comprehensive understanding of the topic.
As shown below, the main areas of personal finance are income, spending, saving, investing, and protection. Each of these areas will be examined in more detail below.
Income refers to a source of cash inflow that an individual receives and then uses to support themselves and their family. It is the starting point for our financial planning process.
These sources of income all generate cash that an individual can use to either spend, save, or invest. In this sense, income can be thought of as the first step in our personal finance roadmap.
Spending includes all types of expenses an individual incurs related to buying goods and services or anything that is consumable (i.e., not an investment). All spending falls into two categories: cash (paid for with cash on hand) and credit (paid for by borrowing money). The majority of most people’s income is allocated to spending.
Common sources of spending are:
The expenses listed above all reduce the amount of cash an individual has available for saving and investing. If expenses are greater than income, the individual has a deficit. Managing expenses is just as important as generating income, and typically people have more control over their discretionary expenses than their income. Good spending habits are critical for good personal finance management.
Saving refers to excess cash that is retained for future investing or spending. If there is a surplus between what a person earns as income and what they spend, the difference can be directed towards savings or investments. Managing savings is a critical area of personal finance.
Common forms of savings include:
Most people keep at least some savings to manage their cash flow and the short-term difference between their income and expenses. Having too much savings, however, can actually be viewed as a bad thing since it earns little to no return compared to investments.
Investing relates to the purchase of assets that are expected to generate a rate of return, with the hope that over time the individual will receive back more money than they originally invested. Investing carries risk, and not all assets actually end up producing a positive rate of return. This is where we see the relationship between risk and return.
Common forms of investing include:
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.
Personal protection refers to a wide range of products that can be used to guard against an unforeseen and adverse event.
Common protection products include:
This is another area of personal finance where people typically seek professional advice and which can become quite complicated. There is a whole series of analysis that needs to be done to properly assess an individual’s insurance and estate planning needs.