Personal finance also helps you make better savings and investment decisions because it focuses on your goals. Your budget (or spending plan) should be built around your day-to-day expenses, including your short-range lifestyle and financial goals. These may include your goals for your family's well-being, shelter, food, clothing, and recreation. It should also provide for future personal lifestyle and financial goals as well.
Savings and investments should be used to match your short-, intermediate-, and long-range financial goals. You save and invest for a purpose, not just to accumulate great wealth. In fact, you save and invest for many purposes, and how you save and invest depend upon the purpose. For example, if you need to replace a household appliance costing a few hundred dollars in the next 12–18 months, you will save differently than you would if you were saving to pay for a child's education in 10–15 years. To make these decisions, you need to understand the relationship among investment risk, time horizon, and investment reward.
Investors are rewarded for taking investment risk. To encourage investors to take higher risks, the rewards must be higher for those higher-risk investments. You can spread investment risk over many different investments. This is called diversification. (There is no guarantee that a diversified portfolio will enhance overall returns or outperform a non-diversified portfolio. Diversification does not ensure against market risk.) You can use this relationship in making savings and investment decisions—low risk for short-term goals and higher risk for longer-term goals.
Investments can also be grouped into several classes to help you better understand their properties. Cash and equivalents are composed of cash, checking accounts, savings, and other short-term, interest-bearing accounts as well as any investment that can be readily turned into cash within a few days without risk of loss due to market fluctuations. Income investments include bonds, certain stocks, and other investments that generally pay periodic interest or income, but whose principal value may vary daily. Equity investments include most stocks and other ownership investments whose principal values vary daily but have potential for future growth. If we have missed anything, then we can put those into a category of "other class" investments. These may include investment art objects, jewelry, gold coins, etc. held for future growth potential, but which are fairly non-liquid from one day to the next. Many advisors go further to specify many other "classes," but unless you are going to analyze your investments under a microscope, these four classes will go a long way toward helping you make some wise personal financial investment decisions.
Cash and equivalents are generally used for short-term financial goals because they are liquid and less vulnerable to market fluctuations. However, you can expect lower returns on them because they pose very little investment risk.
Income investments offer higher returns than cash and equivalents, with a steady stream of income. This makes them suitable for those short-to-intermediate-range goals. While they have higher risk than cash and equivalents, they are less volatile (risky) than equity or "other class" assets. Bonds are subject to market and interest rate risk if sold prior to maturity. Bond values will decline as interest rates rise and are subject to availability and change in price.
Equity class investments are fairly volatile. Just look at the daily Dow Jones averages, the S&P 500, NASDAQ, etc. However, if you look at how they perform over a long time, you find they generally outperform the income and certainly the cash investments. This makes them a good choice for your long-range financial goals. Stock investing involves risk, including loss of principal.
"Other class" assets appreciate in value over time, but they are very volatile, have limited marketability, cannot be quickly turned into cash (illiquid), and generally are not lock-stepped with other investment classes. This makes them a good choice for long-term goals when combined with the asset classes, but they should not be relied upon to meet a particular financial goal with a definite time horizon.
Another interesting thing happens when you combine different asset classes in your overall portfolio. Because the different asset classes do not all go up or down together, the ups and downs eventually smooth out so your portfolio is not as volatile as any one asset class. By combining the asset classes in just the right way, you can help minimize the volatility while potentially optimizing your portfolio return for the amount of risk you are willing to take (risk aversion). This is called asset allocation. (Asset allocation does not ensure a profit or protect against a loss.)
In personal finance, you use your spending plan to help you decide how much you can save and invest each month, then save and invest that money according to your goals, taking advantage of asset allocation to achieve those financial goals with minimum risk.
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