Fin 2802, Spring 08 - Tang

1Fin 2802, Spring 08 - TangChapter 26: Personal Finance

Fin2802: Investments

Spring, 2008Dragon Tang

Fin2802: Investments

Spring, 2008Dragon Tang

Lecture 25Personal FinanceApril 17/18, 2008

Readings: Chapter 26Practice Problem Sets: 1, 12


Where Are We?Where Are We?How?

SecuritiesMarkets

InstitutionsTrading

Delegated investment Why?Market efficiency

Historical performance What?StockBond

EvaluationInternational

So What?Behavioral bias

Technical analysis

Do’s and Don’ts


Personal FinancePersonal Finance

Objectives:

1. Analyze lifetime savings plans with inflation and taxes

2. Analyze the investment objectives of individual and institutional investors.

3. Identify constraints on individual and institutional investors.

4. Analyze and compare major types of investment policies.


Basic Considerations in Developing a Plan

Basic Considerations in Developing a Plan

• Time until retirement

• Allocation to savings

• Life expectancy

• Rate of return

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Figure 26.1 Long Life Expectancy is a Double-Edged SwordFigure 26.1 Long Life Expectancy is a Double-Edged Sword


Planning with InflationPlanning with Inflation

• Inflation reduces the retirement benefit

• To overcome inflation requires greater allocation to savings or higher rates of return on investment.

• Inflation has an added effect when taxes are incorporated


Planning with TaxesPlanning with Taxes

• Taxes further reduces the retirement benefits available

• To overcome the impact of taxes requires larger allocations to savings or higher returns on investments

• Inflation combined with taxes further reduces the benefits available

• Flat versus graduated tax rates


Tax SheltersTax Shelters

• Potential benefits for shelters

– Postponing payment of tax

– Additional earnings on the investment of postponed tax payments

• Effectiveness of the shelter depend on investment performance and variability in tax rates


Tax Shelter AccountsTax Shelter Accounts

• Traditional IRAs

• Roth IRAs

• 401k and 403b plans

• Progressive tax rates

• Capital gains and ordinary income tax considerations


Traditional vs. Roth IRA Tax Shelters Under a Progressive Tax Code

Traditional vs. Roth IRA Tax Shelters Under a Progressive Tax Code


Investing Roth IRA Contributions into Stock and Bonds

Investing Roth IRA Contributions into Stock and Bonds


Investing Traditional IRA or 401k Contributions in Stocks and Bonds

Investing Traditional IRA or 401k Contributions in Stocks and Bonds


Social SecuritySocial Security

•Indexing Factor Series

•Average Indexed Monthly Income

•Primary Insurance Amount

•Performance issues (social security crisis)


Additional Considerations in PlanningAdditional Considerations in Planning

• Financing a child’s education

• Rent or buy decision

• Uncertain longevity

• Marriage, bequests and intergenerational transfers


The Investment ProcessThe Investment Process

• Objectives• Constraints• Policies• Monitoring

Four step process:


Investment ObjectivesInvestment ObjectivesBalance Risk and Return: •How much return do you need?

• How much risk can you stand?

• Tradeoff in the real-world

Life cycle is critical:

• Younger investors: more risk, higher returns

• Older investors: lower risk, lower returns


Amount of Risk Investors Said That They Were Willing to Take by Age

Amount of Risk Investors Said That They Were Willing to Take by Age


The Individual InvestorThe Individual Investor

• Building human capital

• Investing in a home

• Hedging with insurance

• Saving for retirement

Who should manage your portfolio?

Yourself Professional investors

(e.g., personal trusts, mutual funds)


Institutional InvestorsInstitutional Investors

•Pension Funds- Defined Contribution

- Defined Benefit

•Life Insurance Companies•Banks•Endowment Funds


Common ConstraintsCommon Constraints

• Liquidity

• Investment Horizon

• Tax Considerations

• Regulations (mutual funds)

• Unique Needs (e.g., employment)


Specific Investor ObjectivesSpecific Investor Objectives

Type Investor Liquidity Horizon Regulatory Taxes

Individual and Variable Life cycle Prudent Variablepersonal trusts man laws

(for trusts)

Mutual funds Low Short Little None

Pension funds Young, low; Long ERISA None Mature, high

Endowment Little Long Little Nonefunds

Life insurance Low Long Complex Yescompanies

Non-life High Short Little Yesinsurance comp.

Banks Low Short Changing Yes


Investment PolicyInvestment Policy

Considerations:• Asset Allocation• Diversification• Risk Positioning• Income generation• Tax positioning


Asset Allocation and Security Selection for Palatial Investments

Asset Allocation and Security Selection for Palatial Investments


Monitoring PerformanceMonitoring Performance

• Changing market values• Rebalancing portfolio• Dynamic process

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Investments for the Long RunInvestments for the Long Run

• Advice from the mutual fund industry

• Investment horizon determines which risk-free rate to choose

• Make simple investment choices such as TDRFs (target date retirement funds)

• Using options to frame the term structure of interest rates


Do’s and Don’tsDo’s and Don’ts

Do:1. Start early2. Make a serious business plan3. Buy index funds to save costs4. Read “Rich Dad, Poor Dad” etc.5. Commit, be sincere, and work hard

Don’t:1. Take money out of special purpose funds2. Believe in quick-profit with little effort3. Be over-confident4. Make impulsive purchases5. Forget FIN 2802


SummarySummary

•Savings plan with inflation and taxes•The investment process Objectives

ConstraintsPolicies

•Risk-return tradeoff•Impact of the life-cycle and investment decisions•Professional and institutional investors•Asset allocation and security selection•Active versus passive management•Tax considerations•Evaluating and monitoring portfolio performance•Presentations: April 21-24

Business

Fin 2802, Spring 08 - Tang