The Economics of Personal Finance

Economics can be described as a social science that studies how individuals, governments, firms and nations make choices on allocating scarce resources to satisfy their unlimited wants. As complex as the principles of economics may seem, they can be applied in our day to day financial decisions to derive full potential from our personal finances. A few of such concepts are outlined below:

1. The difference between needs and wants
Our actual needs are pretty limited: food, shelter, clothing, companionship. Just about everything else is a “want,” and our wants are essentially endless. Because our resources are limited, we have to make choices about which wants to fulfil.
Also, the way we fulfil our needs involves a lot of choice. Many people believe they have to spend money in certain ways or in certain amounts, when in reality their spending is a choice – or is at least based on choices they made earlier.
For instance, if one is facing loan re-payments that are stretching his income far beyond what he can afford, it is because he chose to take a loan that was not sustainable given his income level. When it comes to borrowing, the rule of thumb is to avoid any debt whose re-payment is beyond 36% of your current net income.

2. Scarcity of resources makes your choices for you
It is a wonderful feeling to believe in a world of endless abundance, but the reality is that at any given point in time, our resources have limits. Whether it is oil in the ground, or the cash in our pockets, there is only so much available to be spent.
Ignoring this reality means that one’s expenses will always outweigh the income available, no matter what time of the month it is. This eventually leads to unsustainable spending by over-relying on credit cards, unnecessary personal loans, among others.
Overlooking the importance of making the sometimes-hard choices needed to responsibly manage money means that one will have even fewer choices in the future.

3. The unsustainable nature of the ‘hedonic treadmill’
In simple terms, the hedonic treadmill means that we quickly adjust to improved circumstances. In essence, a new possession may make us happy for a little while but we soon take our situation for granted. Our expectations continue to rise, and should those expectations be satisfied, again we’d adjust and quickly want more. This means therefore, that we must learn to be motivated by things deeper than money, and to find true happiness in things that go beyond worldly possessions.

4. Every money decision has a cost of its own
“Opportunity cost,” very simply, means what we give up to get something else. In every choice, there’s an opportunity cost. Understanding that our choices have opportunity costs, and examining what those costs are, should help us make better decisions with our personal finances.
For instance, spending beyond our means to satisfy wants instead of needs means that we fore-go the opportunity to earn returns on that money, had it been invested instead.

5. The time value of money
This boils down to a relatively simple proposition: that the shilling I get today is worth more than a shilling I’m promised sometime in the future. This core principle of finance holds that, provided money can earn interest, any amount of money is worth more the sooner it is received, and invested.

Based on these principles, it is easy to see how the broader concepts of economics can be observed to create a better and more rewarding personal financial plan. What it all boils down to is the main principles of personal finance: Always remember to save before you spend, borrow wisely, spend wisely, and most importantly, find happiness in things beyond money.
Please talk to us on how to get your finances on track, or how to improve your existing blue-print.