Financial Planning: It’s Not Just Business, It’s Personal

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Sound financial management is part of the foundation that carries us safely through life’s up and downs and yet sometimes people spend more time comparative shopping for a refrigerator than they do shopping for a financial planner.  Perhaps that’s because they know what a refrigerator is.

What’s cool about financial planning, sometimes called personal wealth management or private wealth management, is that it is first of all personal–the subject is you, who you are, where you have been, where you want to go, what you care about, and what you want to achieve.  Second, there is a clear and compelling conceptual framework that can reliably guide decisions.

The big picture is that each of us has both financial capital (think portfolio wealth) and human capital. (Human capital is the present value of your total lifetime earnings. It is also likely your most important asset.) The challenge is that wealth comes into your life in a rhythm that is completely different from how you use it.  Economists therefore advise focussing on something they call ‘consumption smoothing’:

Getting wealth from times when you have it to times when you need it.

A caveat is that all of this ‘consumption smoothing’ occurs within an important limit: total sources and uses of wealth are always equal.

Here’s a useful schematic of financial planning from an article that I wrote for the Journal of Financial Planning. It reflects the economic theory formally known as ‘life cycle finance’.

Personal Wealth Flow Diagram

 

This picture is a little different from what you might expect.  For example, it is not a picture of a portfolio growing as high as the sky.  Instead, it points to the actual challenges you face in managing personal wealth. Note that you are at the center of this picture, with income and expenses running through you like currents that, awkwardly, are not in the same rhythm. Sources (the top half of the picture) must equal uses (the bottom half of the picture). Savings, including cash reserves, investments, business and real estate interests, are like a reservoir for consumption smoothing.  Insurance is usually experienced as an expense, but if a problem arises, it can bring wealth back into the system (via the dotted green arrow).

Financial planning also incorporates the fact that people care more about what they can safely spend than they care about how big their portfolio is, and further that no one enjoys going backwards financially. In financial planning, safety is a core value. A key metric of planning success is financial freedom, that is, is how much you can safely spend personally.

In other words, financial planning is all about first figuring out who you are and where you want to go, and then arranging to spread out the consumption of your wealth over your lifetime as safely and as agreeably as possible, as your life unfolds in real time. It’s clearly a process, in fact a life-long and very personal process, not a product. It’s not just business.

A topic for future blog posts is that earned income is likely not only your most important  source of wealth, it is also the source over which you have the most influence.  Symmetrically, personal spending, and especially differentiating ‘needs’ from ‘wants’, is the use of wealth over which you likely have the most influence.

Perhaps the following more formal definition of financial planning will now make more sense–and it might even be a lot more interesing to you than how a refrigerator works:

Financial planning is the life-long process of integrating personal values with the management of both human and financial capital for the betterment of self and community.

250 W Coventry Ct. #202, Milwaukee, WI 53217

phone: 414.351.9111

fax: 414.352.9166

www.hoganfinancial.com