The Financial Environment

Personal Finance

Overview of Personal Finance

Financial markets depend on individual investors, including their motivations and risk tolerance for loss.

Personal finance is a concept encompassing everything an individual does to manage their money, including saving, spending, investing, and planning for retirement. An individual's tolerance for risk will strongly influence the investment choices they make. People with a lower risk tolerance are more concerned with not losing money. Thus, they may choose investments with low risk but that still have potential to earn a small amount of interest.

When managing personal finances, a person will often consult a financial planner with ties to an investment broker. Part of the financial planning process is setting fiscal goals and identifying the types of risk that the investor can tolerate. Generally, the planner and the individual analyze risk of loss and risk of volatility. Risk of loss is associated with large returns. For example, if a person has $100,000 in residual income, they may choose to invest the money in a growing business. If the business is a success, the return will be large. If it fails, the investor will lose all of their money. If this $100,000 was the person's retirement savings, the loss would be disastrous. Volatility is the normal fluctuation of a market or stock. Over time it is expected for an investment's value to go up and down. If a 20-year-old investor is investing money to retire at 75, the fluctuations are less important, since there is a long period of time before they will need the money. A 55-year-old making investment decisions has less tolerance for volatility, since the money is needed sooner.

Cautious investors will want to use items such as a basic savings account, a money market account, and certificates of deposit (CDs). Investors with medium risk tolerance may choose to invest in stocks of financially established, healthy companies and mutual funds that balance stock and bond holdings. These investors are less worried about small losses and declines in the stock but are still somewhat reserved when it comes to taking investment risks for fear of experiencing significant losses.

Those with high risk tolerance are unaffected by significant market swings in the short term because they are focused on long-term financial gains. Investments that meet this level of risk tolerance may be higher-risk stocks or shares in a start-up company. An investor's risk tolerance can change from time to time, depending on the liquidity of funds (the ability to convert assets into cash). For example, if a person is investing in a 401(k), they may take more risks in the early years of investment, since it will be many years before the money is needed. Conversely, the closer to retirement an individual gets, the more conservative their investments may become.

Levels of Risk in Investing

There are options for each individual's tolerance level for investment risk, such as low-risk certificates of deposit, moderate-risk mutual funds, and high-risk foreign investment.

Integrating Personal Finances into Financial Markets

The financial environment needs investors with different levels of risk tolerance to satisfy a variety of lending needs, whether a corporation's or an individual's.

One of the more common personal investments is purchasing a home. The process of investing begins with a loan. From this point, the banks and lenders will seek out backers to fund the investment. If it is a home loan, it could then be sold on the mortgage market, a marketplace where borrowers who intend to purchase real estate secure loans originated in primary markets and traded in secondary markets. Depending on the wants and needs of the investor, financial instruments will be issued and offered to the public. Therefore, personal real estate investments have two groups of investors. The first is the home buyer, who will earn long-term revenue in the form of equity in the home, and the second is the asset-backed investor, who will purchase the loan and get revenue from the interest payments, making this system work. For example, Jim and Susan Smith want to buy a home and will need to get a mortgage loan through the bank. The Smiths got a 30-year mortgage, with monthly payments, from Ninth Community Bank. While the bank issued the loan, later it sells Jim and Susan's mortgage to a group of investors who will receive interest on the loan for assuming the risk if Jim and Susan do not pay their mortgage.

A conservative investment option could be a certificate of deposit (CD), a money market account, or an interest-paying savings account. These are backed by the government, carry negligible risk of default, and offer a small interest rate. Individuals may use different kinds of accounts for retirement planning. An individual retirement account (IRA) is a non–company-sponsored account with tax advantages that helps individuals save for retirement. A 401(k) is a retirement investment vehicle sponsored by employers. It is named a 401(k) plan due to the tax code that regulates these tax plans. IRAs, 401(k)s, money market accounts, and CDs are central to retirement planning, a process whereby an individual organizes income goals, makes decisions, and plans actions in advance to achieve retirement objectives.

Long-term investors might consider stocks and bonds. Stocks carry a higher risk of volatility than bonds, and both require some form of expertise, usually from an investment broker. Stocks are ownership shares in large companies and are sold on the stock market, such as the New York Stock Exchange (NYSE), which is the world's largest stock market. The bond market is less volatile, offering securities based on a company's debt. The most common bonds are sold directly from the U.S. Department of the Treasury on auction.

A common investment option is a mutual fund, which is a financial instrument composed of pooled funds for the purpose of collective investment to achieve financial goals of growth or income or both. Since they are groupings of funds, they balance risk and return so that there is less volatility in the fund. There are some other investment options that use derivatives and alternative investments, but these require a high level of expertise and an active investment broker.