Ch. 11 - Personal Finance

Question 1

Financial Literacy

Answer 1

The ability to understand and effectively use various financial skills

Question 2

True or False: People with higher financial literacy make better financial decisions and manage money better

Answer 2

True

Question 3

Why is it desirable for governments to ensure that people are financially stable throughout their lives?

Answer 3

Financial stability is needed to maintain law and order. Otherwise, people’s basic needs (e.g. hunger) will not be met and more people will turn to crime

Question 4

True or False: Most adults understand the time value of money (TVM)

Answer 4

It depends on the country. A 2015 OECD survey shows that only 57% of Canadian adults understand the time value of money. Meanwhile, only 14% of Indonesian adults understand the time value of money.

Question 5

Is there a difference between the quality of investment decisions made by men and women?

Answer 5

Yes. On average, women make better investment decisions since men have a higher tendency of being overconfident

Question 6

Human Capital

Answer 6

A person’s ability to produce cash in the future (present value of future earnings)

Question 7

What is typically an adult’s most valuable asset?

Answer 7

Human Capital

Question 8

True or False: It is rational to spend more than you earn when you are younger

Answer 8

This is mostly true. If you are investing to develop and improve your human capital, spending more than you earn is rational. Note that frivolous spending is not rational

Question 9

True or False: Your human capital at age 65 is 0 (assuming you retire)

Answer 9

False. Even at age 65, your human capital can be $150 000 to $600 000.

Question 10

Financial Plan

Answer 10

Includes an analysis of your overall financial situation (debt, income, savings, and cash flows). It also considers insurance to protect assets, retirement and estate planning, and tax strategy

Question 11

Budget

Answer 11

An estimate of income and expenditure over time. The balance should be zero (since everything should be accounted for).

Question 12

Financial Planning Process

Answer 12

1. Identify current financial situation
2. Identify your goals
3. Analyze your assets, liabilities, cash flows, current insurance coverage, investments, tax strategies, etc.
4. Identify choices and alternative courses of action
5. Evaluate alternatives
6. Develop an action plan
7. Put your plan in action; re-evaluate and revise as necessary

Question 13

Investment

Answer 13

An asset acquired with the goal of generating income and/or capital appreciation

Question 14

What factors need to be considered when determining how much you need to save up for retirement?

Answer 14

• How long do you expect to live?
• How long do you expect to be in retirement?
• How much do you think you will need each year?

Question 15

Retirement

Answer 15

Point in your life when you rely on your financial capital instead of your human capital to survive

Question 16

Asset Classes

Answer 16

Grouping of investments that exhibit similar characteristics:
- Defensive Assets
- Growth Assets

Question 17

Defensive Assets

Answer 17

Provide long-term stable returns with lower volatility. Examples include:
- Cash
- Fixed interest (bonds, indentures)

Question 18

Growth Assets

Answer 18

Assets which generate a return both from capital growth and from the distribution of profits through dividends. Examples include:
- Property
- Alternative investments
- Shares

Question 19

Consumption smoothing

Answer 19

Shifting cash from the future to the present (borrow cash and repay it later)

Question 20

Why do people have a tendency to engage in consumption smoothing?

Answer 20

Most people expect to be better off in the future. They feel comfortable borrowing now to smooth out their consumption over one’s life

Question 21

Secured Loans

Answer 21

Loan where a security is offered by the borrower. Usually attracts a lower interest rate (since security can be confiscated if the borrower fails to pay off the loan)

Question 22

Unsecured Loans

Answer 22

Loan where no security is offered by the borrower. These loans are generally for smaller amounts and have higher interest rates than secured loans

Question 23

Co-borrowers

Answer 23

People who are jointly responsible (equally liable) for a loan or credit

Question 24

Guarantors

Answer 24

People who are responsible for paying off a loan or credit if the borrower does not pay

Question 25

Additional Cardholders

Answer 25

People who the borrower is responsible for paying for

Question 26

Orderly payment of debts program (OPD)

Answer 26

A consolidation program for unsecured debt established by the Government of Alberta. It protects against creditor action and stops collection calls.

Question 27

Biases

Answer 27

Behavioural traits that push you to do something without you realizing it. Includes:
- Overconfidence
- High self-rating
- Optimism bias
- Confirmation bias
- Herd mentality

Question 28

Framing Effects

Answer 28

Behavioural traits that influence you to make decisions based on whether something is presented with positive or negative connotations. Includes:
- Anchoring
- Mental Accounting (House Money)
- Prospect theory/Loss aversion

Question 29

Heuristics

Answer 29

Simple strategies used to quickly form judgments, make decisions, and find solutions to complex problems. Includes:
- Gut Instinct/Affection
- Gambler’s fallacy

Question 30

Overconfidence bias

Answer 30

A cognitive bias where an individual thinks their decisions are better than they truly are

Question 31

High self-rating bias

Answer 31

People tend to think that they are above average. This is an illusory superiority and a cognitive bias

Question 32

Optimism bias

Answer 32

People tend to overestimate the likelihood of a positive outcome and underestimate the negatives

Question 33

Confirmation bias

Answer 33

People like to be correct, and tend to overuse information that confirms their correctness and underuse information that contradicts it

Question 34

Herd mentality bias

Answer 34

People tend to make decisions influenced by the actions of their acquaintances, neighbours, and relatives

Question 35

Anchoring

Answer 35

People tend to rely too heavily on an initial piece of information or we set levels with respect to references

Question 36

Mental Accounting (House Money)

Answer 36

People often mentally separate their money into different categories based on the source of the funds or the intent of the account

Question 37

Prospect Theory/Loss Aversion

Answer 37

Also known as the disposition effect. People often make decisions based on their feelings towards gains and losses rather than the prospect of the final outcome

Question 38

Gut Instinct/Affection

Answer 38

People often like to make choices based on their “gut instinct” or when they “feel” something is right. These choices might be based on good experience and sound learning, but often times there is little logic in gut instincts

Question 39

Gambler’s Fallacy

Answer 39

People often think a departure from a long-term average will correct over the short-term