The Economics of Personal Finance
This is Personal Finance Economics, a newsletter about how to make effective personal finance decisions using economic science.1
My students at SMU are my motivation for this newsletter. For a number of years I have taught a semester undergraduate class in life-cycle economics that I describe as personal finance that respects the intellect of a university student. Many students enter class with little financial background and most leave as financially literate, thoughtful personal finance decision-makers. It is wonderful to observe.
How complex is a personal finance decision? Very complex. In fact, so complex that most financial planners and personal finance gurus will offer a “rule of thumb” answer to a personal financial question. “Establish a budget and stick to it.” “Everybody should save at least 10% of their income for retirement.” “Establish a reserve fund equal to six (6) months of income,” and so forth. These mantras are repeated over and over again.
Consider the question of how to establish a budget. For most people a budget is how much to spend in a month, but how much should that really be? Getting to a solution is amazingly complex. A rule of thumb solution is unlikely to be the best choice. Individuals’ start with different amounts in checking, savings and other financial asset accounts and many have pre-commitments to pay off loans. Individuals’ have different lifespans and prospects, preferences for work v. leisure, the expectation of an inheritance, whether to leave a bequest to family, the desire to give charitably during life and at death, and where they live. The budget solution is also affected by taxation, inflation expectations, the flexibility to move, and risk-return uncertainties of investment choices. Complex indeed.
Every financial planning choice an individual or household makes about investments, education, transportation, taking out a loan, geographic location to reside, retirement, etc., entails economic benefits and costs. Financial decisions alter lives and living standards. Importantly, the very concept of “living standard” hints at the outcome of the effective personal finance budget amount. The highest living standard by definition for an individual (or household) is the highest level of spending achievable, while considering all the economic inputs, prospects, aspirations, and institutional factors.
The starting point for this newsletter begins with background so all readers can learn and have sources to a common body of personal finance knowledge. Subsequent posts will entail guided solutions to common personal finance problems and, on occasion, commentary about financial advice being rendered in other forums.
Economics and technology have given us new ways to think about financial planning and we will explore many of them here. I hope you come on board.