Financial skills: make your dreams come true

Outcomes

• At the end of this short session you should know more about:o Drawing up your own budget.o Identifying and evaluating savings and investment

opportunities.o Planning the financing of your first car or house.o Insuring yourself against risk.

Introduction

• As a field of study, Economics is an everyday part of our lives.• Everyone has unlimited wants, but scare resources to satisfy

those wants.• This forces choices, which entail costs.• Households have to decide to spend or save, firms have to

decide to produce for the local market or to export, government has to decide to build stadiums or schools.

• This course is about applying the tools of economists to your personal finances.

Introduction

• People are often ill informed and reckless about the personal finances, thinking that there will be lots of time later to live responsibly and to save and invest some money.

• If the first step to achieving your financial dreams is to know more about the economy that you live and work in, the second step is to have a budget.

The Economics of it

• The macro economy is the background against which you will be making your work, savings, investment and borrowing decisions.o The GDP is a determinant of personal income.o Inflation increases the cost of living and erodes the

purchasing power of your money: Your employment contract may have a cost-of-living adjustment

clause. Or maybe there is a union that negotiates salary adjustments in

your behalf. Your investments have to hedge against inflation.

The Economics of it

• The macro economy is the background against which you will be making your work, savings, investment and borrowing decisions.o Interest rates determine the yield on your investment and your ability

to borrow.o How will the current interest rate influence your answer to the

following questions: Should I pay off my credit card bill faster than planned? Is it time to stop renting and buy a house? If I buy, should I have a fixed or floating rate? Is the financing offered on that new car a good deal?

• Keeping an eye on the economic news is the key to making informed decisions about your own money.

Why budget?

Budgets are beautiful

• Setting up a budget is as simple as making a list of your income and expenses.

• Then subtract your expenses from your income.

• If you have any surplus cash (savings) you can start thinking about investing it.

• If you are using your savings you need to earn more income or cut spending.

The income-side of the budget

• The key is to start with disposable income.o That is the money that you have left to spend or

save after: You have paid tax. Other deductions, like a pension fund, unemployment

insurance fund, or medical aid contributions.

• In your case disposable income may come from home, a part-time job, grant or student loan.

The spending-side of the budget

• List your expenses item by item.• More detail is better so keep till slips in your wallet

when you use cash.• If you are paying with a debit or credit card your

monthly statement will provide a record of the spending but will indicate Pick’nPay and you will not be able to breakdown your spending further.

• If you find it too exhausting to list every cup of coffee you can use rough aggregates.

The spending-side of the budget

• Make a category for fixed expenses:o These are your expenses that are relatively

constant each month.o E.g. rent, car payment, medical insurance.o These are hard to reduce in the short term.

• And group together the variable expenses:o Like fuel, groceries, cell phone, entertainment.o These you have more control over in the short

term.

The spending-side of the budget

• You may also divide your spending up into:o Essential expenseso Non-essential expenses:

List these in the order of the ones that are most important to you.

If you like going to the movies as opposed to going for drinks, “going to the movies” ranks above “drinking beer”.

For a month, try not spending on the last two items on the list and chances are you won’t miss them.

The spending-side of the budget

• If planning ahead for a month seems like a long time it helps to pay the fixed monthly expenses, like rent, first.

• Then divide the remaining cash in four and work with it week by week.

Pay yourself first

• People often only save the money that they have left over after spending.

• To pay yourself first means to include a savings amount in your budget as part of the fixed expenses.

• If you think of this saved amount as one more fixed payment it becomes easier to set money aside for savings and investment.

Case study: John and Marcia’s budget

• Consider the following case study:o John and Marcia is a young married couple.o They have a two-year old daughter Ashley and

goldfish named Sharky.o John manages a local shoe store.o Marcia graduated recently and is a trainee-

manager at a local bank.o Their combined monthly income is R22 400.

Case study: John and Marcia’s budget

• Have a look at their spending plan 1:o Marcia and John need a second car.o They have decided to practice the “pay yourself

first” approach to saving for a deposit for the second car. How do they pay themselves first?

o What sacrifices do you think they should make in their variable expenses to meet their goal?

Spending plan 1Variable Expenses Meals (home) 2100 Meals (away from home) 700 Utilities 1260 Automobile fuel, maintenance 455 Medical (not covered by Medical insurance) 420 Child care 1820 Clothing 385 Gifts and contributions 385 Magazines and newspapers 280 Home furnishings and appliances 280 Personal care 385 Entertainment 700 Vacation 840 Credit card 385

Variety of other expenses (personal) 385 Total variable expenses 10 780 Total expenses 22400 22400

Case study: John and Marcia’s budget

• One year later:o They have bought the second car.o Both have received salary increases.o And they have payed off Marcia’s student loan.o Now they want to save for a deposit to buy a

house in four year’s time.o Have a look at their expenses – where do you

think they can save? Put together a new budget for them.

Spending plan 2Variable Expenses Meals (home) 1995 Meals (away from home) 350 Utilities 1260 Automobile fuel, maintenance 630 Medical (not covered by Medical insurance) 385 Child care 1820 Clothing 385 Gifts and contributions 385 Magazines and newspapers 105 Home furnishings and appliances 280 Personal care 385 Entertainment 525 Vacation 700 Credit card 385 Variety of other expenses (personal) 385 Total variable expenses 9975 Total expenses 24 640 24 640

Savings?

Introduction• People often only save the money that they have left

over after spending.• To increase your savings it is better to pay yourself

first: include a savings amount in your budget as part of the fixed expenses and set the money aside.

• This next section is about saving and investment of savings as ways to achieve your financial dreams.

• In South Africa we do not save enough.

Savings in South Africa

Saving• The power of saving lies in earning compound

interest.• That is when you earn interest on interest.• Look at the following example:

o Let’s say that you look at your budget, cut some non-essential spending and pay yourself first and you put away R2 000 at the end of this year.

o If the R2 000 earns 8% interest compounded annually you will earn R160 next year.

o In 2011 you will earn 8% on R2 160, which is R172,80.o R12,80 more does not seem like much, but watch this

space.

Saving

• If you keep adding R2 000 each year from the age 20 to 65, you will have put aside R90 000 rand.

• Adding the interest at 8% compounded annually will give you R773 011.

• That is R683 011 more than the saved amounts that you put away!

Factors that determine your return

• In the example there are three forces at work:o The amount saved.o The period that you save for.o The rate of interest that you earn.

Factors that determine your return

• The amount saved:o The amount that you are able to save will depend

on your income, spending and your budget.o If you repeat the story above and are able to put

away R2 500 per year at 8% you will have R966 264.

o Saving only R500 more per year gives you almost R200 000 more at age 65.

o Clearly a key argument for paying yourself first and making that as much as you can.

Factors that determine your return

• The period that you save for:o With savings it is important to start early.o More years = greater return.o Have a look at the story of two savers in your

study material: Karen started saving when she was 22 years old. She

cut her budget, lived below her means and managed to put away R2 000 per year for 12 years. At 33 she stopped saving and started using her income to buy that new car and get the nice flat. She put her savings aside for retirement.

Factors that determine your return

• The period that you save for:o Have a look at the story of two savers in your

study material: When Gerhard started working he spend his income on

a nice car and clothes and he went on vacation a few times. At age 34 he realised that he needs to plan for his future and he started saving R2 000 per year, also at 10% interest, for the next 32 years to his retirement at 65.

o Who do you think had the biggest nest egg?

AgeInterest

rate SavedInterest earned

Total saved at year end Saved

Interest earned

Total saved at year end

21 10% R 0.00 R 0.00 R 0.00 R 0.00 R 0.00 R 0.00

22 10% R 2,000.00 R 200 R 2,200 R 0.00 R 0.00 R 0.00

23 10% R 2,000.00 R 420 R 4,620 R 0.00 R 0.00 R 0.00

24 10% R 2,000.00 R 662 R 7,282 R 0.00 R 0.00 R 0.00

25 10% R 2,000.00 R 928.20 R 10,210.20 R 0.00 R 0.00 R 0.00

26 10% R 2,000.00 R 1,221.02 R 13,431.22 R 0.00 R 0.00 R 0.00

27 10% R 2,000.00 R 1,543.12 R 16,974.34 R 0.00 R 0.00 R 0.00

28 10% R 2,000.00 R 1,897.43 R 20,871.78 R 0.00 R 0.00 R 0.00

29 10% R 2,000.00 R 2,287.18 R 25,158.95 R 0.00 R 0.00 R 0.00

30 10% R 2,000.00 R 2,715.90 R 29,874.85 R 0.00 R 0.00 R 0.00

31 10% R 2,000.00 R 3,187.48 R 35,062.33 R 0.00 R 0.00 R 0.00

32 10% R 2,000.00 R 3,706.23 R 40,768.57 R 0.00 R 0.00 R 0.00

33 10% R 2,000.00 R 4,276.86 R 47,045.42 R 0.00 R 0.00 R 0.00

34 10% R 0.00 R 4,704.54 R 51,749.97 R 2,000.00 R 200.00 R 2,200.00

35 10% R 0.00 R 5,175.00 R 56,924.96 R 2,000.00 R 420.00 R 4,620.00

36 10% R 0.00 R 5,692.50 R 62,617.46 R 2,000.00 R 662.00 R 7,282.00

37 10% R 0.00 R 6,261.75 R 68,879.21 R 2,000.00 R 928.20 R 10,210.20

38 10% R 0.00 R 6,887.92 R 75,767.13 R 2,000.00 R 1,221.02 R 13,431.22

39 10% R 0.00 R 7,576.71 R 83,343.84 R 2,000.00 R 1,543.12 R 16,974.34

40 10% R 0.00 R 8,334.38 R 91,678.22 R 2,000.00 R 1,897.43 R 20,871.78

41 10% R 0.00 R 9,167.82 R 100,846.05 R 2,000.00 R 2,287.18 R 25,158.95

42 10% R 0.00 R 10,084.60 R 110,930.65 R 2,000.00 R 2,715.90 R 29,874.85

43 10% R 0.00 R 11,093.06 R 122,023.71 R 2,000.00 R 3,187.48 R 35,062.33

44 10% R 0.00 R 12,202.37 R 134,226.09 R 2,000.00 R 3,706.23 R 40,768.57

45 10% R 0.00 R 13,422.61 R 147,648.69 R 2,000.00 R 4,276.86 R 47,045.42

46 10% R 0.00 R 14,764.87 R 162,413.56 R 2,000.00 R 4,904.54 R 53,949.97

47 10% R 0.00 R 16,241.36 R 178,654.92 R 2,000.00 R 5,595.00 R 61,544.96

48 10% R 0.00 R 17,865.49 R 196,520.41 R 2,000.00 R 6,354.50 R 69,899.46

49 10% R 0.00 R 19,652.04 R 216,172.45 R 2,000.00 R 7,189.95 R 79,089.41

50 10% R 0.00 R 21,617.25 R 237,789.70 R 2,000.00 R 8,108.94 R 89,198.35

51 10% R 0.00 R 23,778.97 R 261,568.67 R 2,000.00 R 9,119.83 R 100,318.18

52 10% R 0.00 R 26,156.87 R 287,725.54 R 2,000.00 R 10,231.82 R 112,550.00

53 10% R 0.00 R 28,772.55 R 316,498.09 R 2,000.00 R 11,455.00 R 126,005.00

54 10% R 0.00 R 31,649.81 R 348,147.90 R 2,000.00 R 12,800.50 R 140,805.50

55 10% R 0.00 R 34,814.79 R 382,962.69 R 2,000.00 R 14,280.55 R 157,086.05

56 10% R 0.00 R 38,296.27 R 421,258.96 R 2,000.00 R 15,908.60 R 174,994.65

57 10% R 0.00 R 42,125.90 R 463,384.85 R 2,000.00 R 17,699.47 R 194,694.12

58 10% R 0.00 R 46,338.49 R 509,723.34 R 2,000.00 R 19,669.41 R 216,363.53

59 10% R 0.00 R 50,972.33 R 560,695.67 R 2,000.00 R 21,836.35 R 240,199.88

60 10% R 0.00 R 56,069.57 R 616,765.24 R 2,000.00 R 24,219.99 R 266,419.87

61 10% R 0.00 R 61,676.52 R 678,441.76 R 2,000.00 R 26,841.99 R 295,261.86

62 10% R 0.00 R 67,844.18 R 746,285.94 R 2,000.00 R 29,726.19 R 326,988.05

63 10% R 0.00 R 74,628.59 R 820,914.53 R 2,000.00 R 32,898.80 R 361,886.85

64 10% R 0.00 R 82,091.45 R 903,005.99 R 2,000.00 R 36,388.68 R 400,275.53

65 10% R 0.00 R 90,300.60 R 993,306.59 R 2,000.00 R 40,227.55 R 442,503.09

Karen Botha Gerhard Van Deventer

Factors that determine your return

• The period that you save for:o The difference between an early and a late start is

more than double the amount at the end.o When you start out your income won’t be that

much and the cost of living high, but if you can budget well, pay yourself first and get the savings ball rolling, you will see the difference at the end.

Factors that determine your return

• The rate of interest that you earn:o Earning a higher rate of interest will also benefit

your savings efforts.o This is illustrated by the so-called rule of 72.

If you want to determine how long it will take for your money to double, divide 72 by the rate of interest.

At a 10% annually compounded interest rate it will take 7,2 years (=72/10) to double your money.

Factors that determine your return

• The rate of interest that you earn:o The benefits of earning higher interest rates can

also been shown in terms an example.o If you save R2 000 each year from the age 20 to

65, at 8% you will earn R773 011.o If you save R2 000 each year from the age 20 to

65, at 10% you will earn R1 437 809.o If you save R2 000 each year from the age 20 to

65, at 12% you will earn R2 716 460.

Factors that determine your return

• The rate of interest that you earn:o The rate of return is also relevant when you consider that

these examples have all been in nominal terms – not taking account of inflation.

o If you save R2 000 each year from the age 20 to 65, at 10% you will earn R1 437 809.

o But in 45 years’ time R1,4 million will not buy what it does today. Inflation will have eaten away at the purchasing power of your savings.

o This means that you have to make sure that you earn a positive real rate of return:Interest rate – inflation rate > 0

Factors that determine your return

• The rate of interest that you earn:o But keep in mind that earning higher interest rates will

involve making investments that have greater risk.o We will speak more about investment and risk later, but

for now the fact that you may have to risk your savings to beat inflation, has two implications: Again, it is important to start early – it gives you time to make

mistakes and you don’t want to risk losing your savings at age 50. It is important to diversify your investments. Put some for your

savings in safe investments with lower returns and some in in risky investments with higher returns.

Saving

• There are three key pieces of advice about savings:o Pay yourself first. o Start early.o Take sensible risks for higher returns.

Investment

Investment

• Saving and investment are two sides of the same coin.

• Investment return is the additional income earned from your money.

• Risk is the uncertainty that you will receive the expected return.

• Typically, the greater the risk, the higher the expected return.

Investment

• Your risk preference refers to your attitude towards risk – how willing you are to take risks.

• Types of risk preferences:o Risk takers: easily take risks to get higher returns.o Risk avoiders: Avoid high risks even if the returns

are higher.

Types of investment risks• Financial risk

o Is the risk that you will not get your money back at all.o This is particular to investing in a business.

• Market price risko Is the risk that the price of the investment will go down.o This rarely happens to savings accounts, but the prices of stocks,

bonds, unit trusts and real estate fluctuate with demand and supply• Liquidity risk

o Refers to the risk that you won’t be able to turn your investment into cash when you need it.

o Stocks listed on the JSE are very liquid – you can sell them at any time, but real estate is not liquid.

Types of investment risks• Risk of inflation

o We have already said that over time inflation eats away the purchasing power of your money.

o Thus, when you make an investment there is the risk that the real rate of return is negative.

o That means that you will be able to buy less with the money when you get it back than you would have when you made the investment.

• Risk of fraudo Sometimes investments are designed to deceive and defraud

investors.o This typically occurs in schemes that do not involve established banks

and brokerage firms.

A side note on Ponzi schemes

• Very now and again someone comes along promising unbelievable returns over short periods.

• The latest is Bernard Madoff in the U.S. who defrauded investors of $50 billion.

• One of the first was Charles Ponzi in 1919.• The key to a pyramid scheme is to pay off early investors with

capital raised from later entrants.• As long as new investments continue to come in the door, the

earlier adopters reap fat rewards.• But when no new investors join the pyramid at the bottom,

the whole thing collapses.

A side note on Ponzi schemes

• There are many examples:o The first was William Miller, 1899. He defrauded New York

investors of $1 million promising 520% returns.o Ponzi promised 50% return in 90 days.o There are many more recent examples from the U.S.o In South Africa we have had examples such as Fidentia,

Krion.

• The key to avoiding this is to ask what is being done with the money to earn those rates of return. When that is not clear, it is probably too good to be true.

Types of investment

• Hiding you savings under your mattress.• Savings accounts

o Interest rates vary between 1% and 5%, depending on the balance on the account.

o You can open such an account with little money.o And it tends to be quite liquid.

Types of investment

• Money market fundso Your money becomes part of a fund that makes

short-term loans to businesses and government.o For each rand that you put in, you can expect your

rand back with some interest.o The interest rates are usually higher than those of

savings accountso But the investment still has low risk and quite

liquid.

Types of investment

• Stockso Stocks are shares of ownership in a company listed on the

JSE.o The return depends of what happens to the price of the

shares and the dividends that you receive.o This is a risky type of investment, but the returns may be

high.o The investment is still quite liquid and the shares can be

bought and sold at any time that the JSE is open.

Types of investment

• Unit trustso Unit trusts are funds that typically invest in a portfolio of

shares (they make other investments too).o Some funds invest in high quality or blue-chip stocks and

others in more speculative stocks.o The differences between investing in unit trusts and

investing in stocks yourself: Unit trusts are more diversified, so you don’t have all your eggs in

one basket and the risk is lower. You can start with smaller amounts.

o The investment is also liquid – you can sell your units back to the fund at any time.

Types of investment

• Real estateo Most investors in property buy the house that

they live in.o Houses can increase in value, but as we are seeing

at the moment, house prices can also fall.o Property is an illiquid investment and it may take

a lot of time to find a buyer (on your own or through an estate agent).

Risk vs. Return

Speculative stocks

Real estate

Individual stocks

Unit trusts

Money market funds

Savings accounts

High risk and return

Low risk and return

The steps to good investing

• Keep in mind that investment is a marathon.• Get your mind set right.• Get good advice.• Get rid of debt.• Decide what you need, income or capital

growth, or both.• Select an asset class to invest in.

The steps to good investing

• Understand the risks.• Know your risk profile.• Diversify.• What is your investment style: Value vs.

growth investing.• Consider liquidity.• Consider costs.• Consider tax.

The steps to good investing

• Measure the results.• Rebalance your portfolio.• When an investment matures – when to cash

in.• Start again at the start.

The use of credit

Introduction• We have shown that savings and investment are important

components of your personal finances.• At the opposite end of the spectrum lies your use of credit.• Just about every adult in South Africa uses some form of

credit at some stage.• Some people are not afraid to swipe, others are opposed to

having debt.• Used in a smart way, credit can help you now and in the

future.• But if you are not smart it can lead to financial problems and

broken relationships.

Debt in South Africa

What is credit?• Using credit is to use money that you do not have.• Your bank provides you with a loan in agreement

that you will pay it back later.• You will have to repay the debt with interest.• People get loans to buy cars, a home, major

appliances, to make home improvements, to pay for university education etc.

• So the credit can be in the forms of the overdraft facility on your cheque account or credit card, personal loans, vehicle financing, mortgage bonds etc.

What is credit?

• Keep in mind that a credit transaction always has two sides:o The borrower gets a loan to buy and consume

things today, but pay for it in the future.o The lender makes the loan, but for him/her it is an

investment that and they want to get a return on their money.

o The cost/compensation is interest paid and earned.

Advantages of using credit

• Over your life time you are likely to have major expenses when you are young and don’t have a large income or lots of savings – like paying for your education or buying a first car or house.

• Education and housing can be an investment and cars and appliances are durable consumer goods that are used over a long time.

• Credit allows you to use a good or service today and pay for it later.

Advantages of using credit

• It would be impossible to save up for a house, or a car or to go to university, but using credit allows you to smooth your consumption over time.

• It is also very handy in case of emergency expenses that you cannot pay from your current income or savings.

Disadvantages of using credit

• When credit is easily available you may end up with a lifestyle above your means.

• Loans and their interest have to be repaid first, before you can spend or save the rest of your income.

• This may later require sacrifices over goods and services that have already been consumed.

• The key is the smart use of credit.

How do you get credit?

• Lenders typically look at the “three C’s” before they approve a loan:o Character

Will the applicant be responsible and repay the loan?o Capacity

Does the applicant have enough discretionary income to comfortably make the repayments?

o Collateral Will the loan be secured or guaranteed by collateral that can be

sold to repay the debt in case the borrower defaults on the loan.

The importance of a good credit rating

• It is important to build and maintain a good credit history.

• Lenders compile credit reports in which your credit history is rated.

• A good rating indicates that in the past you have repaid your debts on time.

• A poor rating indicates overdue or unpaid accounts.

The importance of a good credit rating

• Lenders get this information from credit bureaus.• These bureaus collect and store information on

liquidations and list the names of people who are incapable of paying their debts.

• When you apply for credit, the credit information bureaus are contacted for more information about the applicants.

• No one will supply credit to anyone who does not regularly repay their debts.

How to establish and maintain a good credit record

• Borrow sensibly:o Only the amount that you need.o That means that you have to budget first and make sure

that you can afford the installments.o Credit repayments should be between 20% and 30% of

your monthly income.o Know how much you owe at all times.

• Develop good savings habits so that you can handle a financial emergency without borrowing.

How to establish and maintain a good credit record

• Repayment:o Always pay your bills on time.o Pay the full installment amount that is owed.o Contact lenders immediately if you expect to have a

payment problem.o Never ignore a letter of demand for payment.o Never ignore a summons to court for non-payment.

How to establish and maintain a good credit record

• Don’t apply for too many credit cards – even if you don’t use them, the credit limits are taken into account when you apply for more credit.

• Ensure that you supply accurate information in new applications.

• Check your credit record regularly to ensure that the information is accurate.

• Beware of fraud and identity theft.

A note on store credit• In today's harsh economic climate, many people do not have

available cash and so resort to buying on credit. • Most clothing chains offer both the traditional six-month,

interest-free account (you merely pay for your purchases over six months, at no extra cost), and an extended payment plan, 12 to 24 months, on which you pay interest.

• Edgars:o Grey card: A six-month plan. No interest is charged on this account

unless the accountholder falls behind on monthly repayments, and then interest at 32% a year is levied.

o Red card: a 12-month payment plan where interest is charged. The interest is 2.66% a month, which works out to 32% a year.

A note on store credit• Bally Spitz:

o A six-month interest-free account as well as a 12-month account, with interest.

o Interest charged on the cards is the same as for "the ordinary bank credit card" at 35% a year.

• Truworths:o Offers a six-month interest-free account, as well as extended payment

plans (12, 18 or 24 months) where interest is charged at 2% a month - an effective 26.5% a year.

• Woolworths:o The Woolworths card is different from other store cards in that it

works pretty much the same as a bank credit card. o Woolworths charges 30% interest on any amount owing up to R6 000,

and 29% for amounts above that. o No interest is charged on revolving credit for up to 55 days (this works

like a bank card), so to avoid paying interest, account holders should aim to pay the full amount owing before the due date on their monthly statement.

Finally some tips• With credit the key is to use it wisely:

o Borrow only to finance the big ticket items like houses and cars.o Don’t live above your means and use debt to pay for it.o Sell investments that have not performed as well as you expected and

use the proceeds to settle some debts. o Any surplus cash should be used to repay high-interest bearing loans

first, and then interest-free loans and other creditors. o Never juggle credit by repaying an old debt with a new one. This only

postpones the problem. o Consolidating your debts is a viable option, but only if it's not an

exercise in juggling credit. Mortgage finance is generally cheaper than overdraft or installment credit finance, so it makes financial sense to consolidate your debts using your mortgage bond.