Tuesday, September 25, 2012

7 Pillars of Financial Literacy, Explained (Part 1)

The "7 Pillars of Financial Literacy" that I presented in the last post is an integrative framework that provides an overview of my (and Project Be's) version of "financial literacy". It is meant to show the user the breadth and depth of the subject, and how subtopics are related to each other. Also, it is a tool that we can use to evaluate how much we already know about financial literacy, determine how much more we want to know, and formulate a strategy that will help fill identified knowledge gaps.

In this post, I will discuss each pillar in detail and articulate ideas that I will present in our "Training of Trainors" Financial Literacy Workshop this weekend.

1. Being "financially literate"

What is financial literacy and why do we have to be financially literate? Financial literacy is understanding the "language of money," not being an expert; you don't have to have an MBA, be a CFA, an economist, or an investment banker in order to be financially literate. Like it or not, money matters are a big part of everyday life; so the same way we have to know a bit of math, of history, of language, of art, of culture to be able to have a "good" quality of life, we also have to know a bit of finance--these are the stuff the world runs on.

In a more specific sense, financial literacy equips us to be able to make sound and informed economic decisions: it tells us how to identify available alternatives and how to objectively evaluate these alternatives to come up with a decision, given that outcomes depend not only on our decisions/actions but also things that are beyond our control. Finally, and most importantly, financial literacy helps us cope with and prepare for the fact that we don't know what's going to happen in the future.

2. Defining your financial goal

It's easy to know what you want--be a billionaire, be a rock star, "own a Jollibee," and so on--but getting what you want is another matter. To go from here to where (or what or who) you want to be, you fist need to do two things: know where you currently are and know exactly where you want to go.

It is important and necessary to breakdown your financial goal or dream into something that is--for lack of an equally appropriate but non-acronym term--SMART: Specific, Measurable, Attainable, Relevant, Time-bound. Reshaping your goal into something SMART does two things: it provides a way to know whether you have attained your goal or not and it better helps you figure out concrete steps that will take you to your goal. 

Knowing "where you are"--that is, your current financial status--is pretty straight forward. You get your "net worth" or "net wealth" by listing and valuing everything your own and subtracting how much you owe: if your net worth is positive and substantial, then you're off to a great start; if it's negative (i.e., if you're a net borrower), then you need to get out of that hole first before you can take the first step towards your financial goal. Then you measure your capacity to increase to your wealth--your "net earnings"--by taking your regular income and subtracting recurring expenses.

The SWOT tool which I discussed in a prior post is also useful in coming up with a plan to reach your financial goal.

3. Budgeting

I bet that a good majority of those who emerge from the second pillar will feel that they don't own enough and they don't earn enough. The best way to address both issues is to improve our capacity to accumulate wealth by boosting your income and controlling your expenses, which result in more savings.

It's also important to understand the reasons for saving, how it's not just something that we have to do, and that essentially it's just one of several ways to cope with uncertainty about the future (please read this post for more details).

4. Dealing with life's uncertainties

As I mentioned in item 1 above: one thing that makes financial literacy absolutely necessary is that we only have an unclear picture of what will happen in the future, and that some of the things that may happen can leave us in a worse financial position and take us farther from our financial goals. Accidents, sickness or death in the family, natural catastrophes, and higher costs of goods and services (such as weddings, honeymoons, tuition fees, houses, etc.) in the future are things that we have to prepare for financially.

There are three ways of preparing for these unforeseeable, substantial, and necessary future expenses: insurance, cash in the form of an emergency fund, and debt. Insurance is almost always the cheapest alternative because: 1) risk is pooled and the costs are shared among many parties; 2) we can use forms of insurance that are subsidized by the government. Cash has an implied cost (called opportunity cost) since we usually earn very little interest (if at all) on what we set aside for emergencies. Finally, we can always just borrow when we need the money, but often only at very high interest rates.

To be continued in Part 2.

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