Financial Planning Is All About Trade-Offs
Financial planning is the process of properly managing your finances to achieve your goals. It is a broad area encompassing many facets of your life because most decisions regarding your life somehow involve money. Any money that you don’t spend to support your lifestyle is available for saving and investing. How much you choose to spend or save, and what you do with your savings, will largely determine your lifestyle and wealth.
Professional athletes and Hollywood stars notwithstanding, most people have a finite amount of wealth and a limited ability to produce income. That limited wealth and income must support your lifestyle. You cannot afford to save enough for the future and buy everything you want in the present, so you will constantly face saving-versus-spending decisions.
Americans seem to have a particular problem with this; we all think we are going to be rich one day. We continue to spend as if our future riches will one day make up for our current lack of saving. However, very few of us will actually end up “rich,” so I wouldn’t advise anyone to pursue this strategy.
Economists teach college freshman how people make spending choices by plotting graphs of the demand for guns and butter. Supposedly, individuals make rational choices as to how many guns and how much butter will make them happiest given the total amount of money they have to spend.
For example, if guns are three dollars and butter is one dollar, and the consumer has ten dollars, which combination of guns and butter will make him happiest? Is it four butters and two guns? Or is it a single butter and three guns?
Here, the consumer faces a trade-off between allocating more of their resources toward butter or toward guns. The choice is based on each consumer’s perception of each good’s marginal ability to make him happy. A rational consumer will strive to maximize his happiness with his limited amount of money. Remember, it is the consumer’s perception of what will make him happiest, so consumers are not always strictly rational.
Daniel Kahneman won the 2002 Nobel Prize in Economics for his work in the field of behavioral economics, which examines how our biases and emotions influence our decisions. Most decisions investors make are not based on a coolly rational, unbiased analysis of the subject matter. We are not strictly rational beings.
Over your lifetime you will make thousands of decisions involving different trade-offs that will greatly impact your finances. Proper financial planning will allow you to make the most of your money, and hopefully, to maximize your happiness by helping you to achieve the goals that are most important to you.
You will have to make some difficult choices. Financial planning is all about trade-offs. Ultimately, you will weigh your choices and their likely consequences, to make your decisions and forge your own path.