Personal Finance I, The Essential First Step To Investing

In one of my older articles, How To Start Investing Part I, I listed getting your personal finances in order as the very first step to take in investing. In Part II, I briefly summarized the importance of that step. In this article, I will elaborate in more depth, to explain why personal finances is such an essential first step and prerequisite in becoming a successful investor.

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Why Is Personal Finance Important?
Wikipedia defines Personal Finance as “the application of the principles of finance to the monetary decisions of an individual or family unit. It addresses the ways in which individuals or families obtain, budget, save, and spend monetary resources over time, taking into account various financial risks and future life events.”

Personal finance is an important and essential prerequisite to investing.  It is the most basic first step an individual needs to take, prior to making any investments or learning about different investments. Getting ones own personal finances in order and making them efficient, helps to develop and hone the basic skills & knowledge.  It creates the solid foundation on which investing will build upon.  Without that foundation, an individual will not become a successful investor and will end up losing money.

The recent housing bust and credit crisis, has finally brought out the fact that the average individual does pretty poorly when it comes to managing personal finances, and that the trend has become a growing problem over the years.  According to a May 2009 report by the Certified General Accountants Association of Canada (CGA-Canada) a survey showed that 42% of respondents said their personal debt was rising in the past three years, and 21% couldn’t manage their debt.  Using data Statistics Canada the report found that debt accounted for 23.7% of Canadians’ net worth.  The report also found that 32% of non-retired respondents said they were not devoting any funds towards saving, even for retirement!  In the U.S. the situation is even worse.  Scotiabank Group data indicated US consumers use a 42% more debt per dollar than Canadians, and that Americans now have the highest household debt level on record for their country. On average, people do not have a budget, live beyond their means, have increased their debt loads to unsafe levels, and have accumulated very little in terms of savings and investments.

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How Is Personal Finance Related To Investing?

Personal finance utilizes and builds upon and uses similar skills, knowledge, and encompasses many of the same activities that are required for successful investing.  Some skills & activities include:
– Assessing the financial situation (assessment of businesses and investments financials).
– Setting financial goals & budgeting (allocation of capital).
– Planning (short & long term thinking).
– Execution of the plan (ability to follow through).
– Reducing expenses (identifying financial efficiency).
– Prioritizing expenses.
– Time management.
– Obtaining financial resources (raising capital for investing).
– Tracking finances.
– Regular & continual re-assessment.
Some knowledge areas include:
– Financial statements – Income statement, balance sheet, cash flow.
– Taxation.
– Financial terms & definitions.
– Basic financial services & tools (accounts, etc).
– Debt.
– Risk assessment & mitigation.
– Stress control – Managing the stress one might experience in managing finances (especially if there are difficulties).

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Why Is Personal Finance A Prerequisite To Investing?

Skills & Knowledge:
Without the basic skills & knowledge, the individual will not be able to properly learn about investing, understand which investments will be desirable at different times or situations, assess investments, allocate capital, raise capital, prioritize investments, perform analysis, understand financial implications that a situation may have, assess risk, etc (too many to list).  To put this in to perspective, I will give a few different examples:

– Debt – Some large investments such as a rental property, or related to a business endeavor will need an investment or business loan.  Do you think a bank will give you an investment loan if you cannot manageable your current levels of debt, or have a bad credit rating?  If you are somehow able to get a loan, how would you calculate if the rate is low enough in order to make an investment profitable?  If you were to lend money to someone with interest, what would you look at to determine if they can keep paying interest?  How about if you lent money to a company by buying subordinated notes?

– Basic definition/Terminology – RRSP? TFSA? (Canada).  Roth IRA?  401K? (US).  What is does compounding mean and how does it work?

– Financial assessment – What is your monthly cash flow?  What is your net worth?  Can you calculate them for a company?  Where would you begin?

– Taxation – How are dividends treated on your income tax, compared to distributions made up of a mix of return of capital, dividends, interest, and other income?  What is your tax rate?

– Risk – What are the possible risks of loss of employment income?  What implications does it have?  What is the likelihood of that event occurring? What mitigation strategies do you have in place?  For a company, what immediate implications would loss of one revenue stream have?  What would you look at to determine the likelihood?  What kind of risk mitigation strategies should a company put in place?

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Attitude & Mindset:
Not only does having good personal finances develop the skills and knowledge that is necessary, it also lays the foundation for development of the right attitude, mindset, and other qualities that an investor needs to have to be successful.  This is essential because the investor will often find themselves in situations which will require the right qualities and mindset in order to make sound investment decisions.  Some qualities include:

– Self-awareness – Identifying wants, emotional state at any time, competencies, strong/weak areas, areas for improvement.  This helps to eliminate mistakes, mitigate risk, and improve success. How can you invest in things you understand, if you don’t know your own circle of competency and current limits?

– Self-control – Staying within limits (budgeting), discipline, not giving out to greed (reduction in discretionary spending and short term desires). In investing you’ll have limited capital, and must resist the lure of potential higher returns when your analysis warns you of the higher possibility of realized risks.

– Logical/rational thought & decision making – There will be many times when negative/difficult/challenging situations occur, where the investor needs to be able keep emotions from influencing their decisions.  Emotional decision making usually results in investment losses. Difficulties in personal finances develop this thought process by forcing one to make tough choices (usually against their emotions of the moment).

– Patience – Being able to wait for investments to play out and return profits.  Many times the average investor will take short term gains (or losses), as they are too impatient to wait for the long term profit. Patience is also required to see the investment plan (long term) through. If one can’t even be patient enough to go through personal finances first before thinking of purchasing investments, how can one be patient enough to invest?

– Continual self-improvement and education – Improving one’s weaknesses and constant accumulation of knowledge, allows one to make better investment decisions. Making your personal finances efficient, forces you to improve yourself and become more financially educated in the process.

– Independence – The average investor is not too successful.  The above average investor usually does things that the average investor doesn’t do.  To be above average, one needs to be able to think and act independently, based on their own homework and research, and assessments. The average person follows the crowd with expenditures and has a habit of comparing with their peers.  Tough choices made in managing your personal finances breaks you away from the crowd.

– Effort & work ethic – Simply put, nothing comes free. Managing personal finances takes work. Investing has greater rewards, only if you are willing to put in some work.  You can’t be lazy.

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As you can see, managing personal finances is an absolutely necessary step before investing. The skills & knowledge one attains through managing personal finances are applied to investing.  It also uses similar thought processes, and demands the same qualities.  However, it is important to note that they are not the same thing. Investing develops on top of what is learned/gained through personal finances, and develops them many steps further.  There are also many areas of specialized knowledge in investing, which depends on the investment tools used. Personal finance alone is NOT enough for investing, but it is the first step. We all learned the alphabet, before we started reading books.  If we didn’t, we wouldn’t be able to make sense of what we reading.

Next week I’ll discuss some practical tips and steps to get started and some ideas that relate personal finance and investing together.

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Feel free to ask questions you might have or post comments.  Also take the poll question on the sidebar located on the right hand side!

Thanks & Happy Investing!
The Investment Blogger © 2009

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