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Chapter review questions....

Multiple choice questions

For each of the following questions, choose the best alternative.

1. The ability to understand money and how to manage it is called a. financialliteracy. b. budgeting. c. gross income. d. financialplanning.

2. Allbutoneofthefollowingisaconsequenceofpoorbudgeting: a. havinginsufficientincometobuyneedsandwants b. havinginsufficientincometopayexpenses c. using scarce resources wastefully d. being able to meet large irregular bills.

3. Whichofthefollowingstatementsbestdescribesthepersonalbudget? a. thebudgetguaranteesthatexpenditureislessthanincome. b. thebudgetguaranteesthatincomeislessthanspending. c. thebudgetrecordsfuturepatternsofincomeandspending. d. thebudgetrecordspastpatternsofincomeandspending.

4. Whichpairofprinciplescreatesthebestbudgetforanindividual? a. keepallrecordsANDdon’tleaveanyfundsforemergencies. b. payyourselffirstANDthenmakesureallyoumoneyisspentongoodsandservices. c. payyourselffirstANDconsidersavingasanexpenseitem. d. useacomputerbudgetmodelANDmakesureyouusealotofexpenditurecategories.

5. Compoundinterestdiffersfromsimpleinterestbecause: a. it takes into account the future value of money. b. interestisbasedontheoriginalprincipalamount c. interestisbasedonprincipalplusinterestattheendofthepreviousperiod. d. itisbasedoninterestearnedaftertaxationhasbeenpaid.

Questions

Try to write a half page on the following topics. Good answers will be clear, logical, use appropriate terms and relevant examples. Try to be unbiased. Do not give opinions unless you can justify them.

1. Describe the objectives of a personal budget.

2. Outline the steps to be used in creating a personal budget.

3. In general terms, how might personal budgets be expected to change through the stages of life?

4. Explain the difference between simple and compound interest.

Research

Compile details of your family’s expenses over a three month period. Use one of the budgeting techniques described in this chapter to record them in a format which can be used to build a budget.

As we saw in chapter 3, budgeting is an important aspect of financial literacy. Effective management of your income and expenses creates a base for the next stage of personal finance - financial planning. Personal financial planning is more important in today’s economy than it used to be because people live longer and the government cannot be relied upon in the future to support the demand for pensions and social security that the aging population has helped to create. People are also more knowledgeable about their own financial affairs and more conscious of the need to plan for the future - nobody wants to be poor at the end of their working life.

This chapter introduces some of the key concepts that will help you to understand the nature and importance of financial planning, including:

• the objectives of financial plans• the nature of financial assets• the relationship between risk and return• the need for diversification and establishing investment portfolios• the role of psychology in financial planning.Some of these topics are very complex, so this chapter is introductory.

Financial planningThe objective of financial planning is similar to the personal budget, in that it is based on

planning what to do with your income. The difference is that you are buying financial assets, not goods and services, and you are interested in the future, not the past.

To be effective, financial planning should start early in your working life, not late, Financial planning is a classic case of ‘failing to plan is planning to fail’. Like budgeting, there are some steps you can follow:

• Assess your financial situation. It’s a good idea to start off with a list of the values of your personal assets (e.g. car, house, clothes, stocks, bank account), and liabilities (e.g.credit card debt, bank loan, mortgage).

Personal financialplanning

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• Set goals. Setting financial goals establishes some direction for the plan. The financial plan for someone wishing to retire at age 50 with $3 million in assets would be different from that for someone seeking to retire at age 65 having paid off their house. The plan for the first person would be aggressive, the second conservative.• Implement your plan. Putting the plan into place requires your attention, time,

knowledge and perseverance. It’s wise to seek assistance from professionals such as accountants, financial planners, investment advisers, and lawyers because financial planning is complex.• Monitor your plan. As time passes, one’s personal financial plan must be watched and

reviewed for possible adjustments or reassessments.

Learning activity 4.1 Two investorsJoe (25) saves money for retirement by investing $200 per month into an account paying 7% annual interest compounded annually. Joe’s cousin, Bob, also 25, spends his money. From ages 25 to 35, Bob drives a nicer car than Joe and takes three overseas holidays each year.

At age 35, Joe chooses to work part time. He does not invest any more money into his retirement fund, but leaves it invested in the account paying 7% annually. At age 35, Bob begins investing $200 per month toward retirement - his account also pays a 7% rate of return, compounded annually.

Which of the two men do you think will be better of at retirement? Why?

It is very difficult to follow the steps unless you know a few of the principles behind financial planning. We introduce these below.

Key concepts in financial planningThe key things to understand when you are developing a financial plan are:• the nature of financial assets• the relationship between risk and return• the importance of time• the importance of diversification and a portfolio of assets.• how to evaluate financial decisionsWe can only introduce these concepts in this short chapter. Expertise in financial matters

only comes after considerable study and experience.

Financial asset classesA financial asset is anything purchased in the hope of getting a future return from it. Some

examples of financial assets are:• cash - notes and coins you have on hand, plus savings accounts at banks or other f

inancial institutions that can be quickly accessed.• fixed interest securities - term deposits at the bank, or bonds and securities issued

by private companies or governments to raise funds for their operations. They are called ‘fixed interest’ because the interest rate is known and fixed for some period.• shares - private and public companies have shareholders who own part of a company,

the proportion of which is governed by the number of shares owned. Shares in public companies can be traded on the open market we know as the stock exchange. People can buy shares in Australian companies, or overseas companies (although buying international shares can be more difficult).• property - real estate held as land (unimproved property) and/or buildings (improved

property). Property may be residential, commercial, agricultural or industrial

• other assets - includes more specialised financial assets such as jewellery, antiques, collectables, precious metals, stock options, derivatives and so on. The list is long - people collect antique golf clubs, fishing rods, Barbie Dolls, teapots, handtools and many other things!. Financial assets include a lot of things!. What they have in common is that they all offer their

owners the potential of recurring gain or capital gain.

Learning activity 4.2 Financial assets classificationAlfons is now 47 years old, and has accumulated the assets in columns 1 and 3. Classify them according to the five categories used above.

Asset Classification Asset Classification

an apartment rented to tenants

$24,000 in a 3 month bank deposit

$250,000 in sharesan insurance policy

a collection of old Macintosh computers

$3000 in cash

Learning activity 4.3 Old cars and plates - financial assets?Conduct an Internet search using a phrase such as ‘vintage cars Australia’. What types of cars are offered for sale? What factors determine their selling price? To what extent could they be considered as financial assets?

Then find the Oztion web site at http://www.oztion.com.au. Search the site for ‘collector plates’. What types of plates are offered for sale? What factors determine their selling price? To what extent could they be considered as financial assets?

Managed funds should be mentioned at this point. Managed funds collect the surplus funds of many individual investors into a ‘pool’. The pool is then invested in different asset classes (e.g. shares, property and bonds) by a professional fund manager. Investing in managed funds gives you access to many different types of investments, some of which are not normally available to individual investors. When you invest in a managed fund, you are allocated a number of ‘units’. Each unit represents an equal portion of the market value of the portfolio of investments. Each unit has a dollar value, known as the ‘unit price’.

Managed funds are useful investment tools for many people. They have become very popular because few people have the time, knowledge or energy to manage their own investments.

ReturnsThe holder of a financial asset is entitled to earn a return, just the same as a worker is entitled

to earn a wage or salary. A financial asset can have two types of return to its owner. Recurring gains (e.g. the interest you receive on a bank account, or dividends that you receive from a company of which you are a shareholder, or the distribution you receive from a managed fund) are regular payments that the owner of the asset receives from the borrower. Capital gain is where you can sell an asset for more than you purchased it. Note that it is possible that a financial asset could bring a capital loss - when you sell an asset for less then the original price.

Total returns on the investment obviously include both recurring and capital gains. If you had a $1000 bank account paying 4 per cent interest, your recurring gain would be the 4 per cent interest ($40) received at the end of the year. But you would have no capital gain because the value of the deposit does not change. On the other hand, shares offer both recurring and capital gain. If you held 1000 BHP Billiton shares paying 90 cents per share dividend, your

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would receive a recurring gain of $900 before tax. The percentage return would depend on what you paid for the shares. Had you paid $40 per share, the total value of your shareholding would be $40,000. A $900 return on these shares is equivalent to a 2.2 per cent return on your original funds. If the current price of BHP shares was $45, you have also made a capital gain of $5 per share. This is an ‘on-paper’ gain unless you actually sell the shares. Note that these returns are before tax. The $5 capital gain is 12.5 per cent of the $40 purchase price, expressed as a rate, so the annual total return is about 14 per cent!

Learning activity 4.4 DividendsDividends are taxable payments declared by the Board of Directors of companies to be paid to the shareholders out of current or retained earnings. They are often cash payments, although at times you may get the dividend in new shares. The Australian Securities Exchange (ASX) publishes dividend details at http://www.asx.com.au/asx/markets/dividends.do

Find this page then type in the 3 letter codes of some public companies [e.g. BHP (BHP Billiton); WBC (Westpac); JBH (JB Hi-Fi); RIO (Rio Tinto Limited); CBA (Commonwealth Bank)] to the check box marked ‘most recent dividend’. What proportion of the share price is the dividend? How often are dividends paid?

RiskMost people think that risk is the chance that something will go ‘wrong’. The term has a

different meaning in economics and finance, where risk is the chance that the return from an investment will be different than what was expected.

Cash (notes and coins) carries no risk, because cash has no return. Bonds and bank accounts have very low risk, because the interest rates (recurring gains) are known when the investor buys the asset, although there is a chance the rate could rise or fall during the life of the deposit. Shares involve higher risk, because the share price rises and falls in line with market expectations, and dividends paid to shareholders rise and fall depending on the profitability of the company and the state of the economy.

Antiques, precious metals and collectors items are very risky. Their value can rise and fall by large amounts. Prices of the 1930s porcelain dinner set; old Land Rovers and dolls’ houses go up and down, following the laws of demand and supply, and driven by the changing preferences of collectors.

The risk/return relationshipRisk and return are related - generally, a financial asset which carries low risk also offers a

low return. Why should this be the case? The relationship between risk and return for various asset classes is a positive relationship,

as shown in figure 4.1 (greater risk, greater expected return). Cash assets carry low risk, but they also provide investors with low returns. Growth assets, on the other hand, are higher risk, but offer the promise of higher returns. Growth assets, by the way, are assets where investors target capital gain more than recurring gain (e.g. shares, property). Defensive or conservative assets, as the graph shows, are medium risk / medium return. Balanced or moderate growth assets offer higher returns, but carry more risk.

The table is an alternative way of presenting the same information. It shows that cash has low risk and moderate return (income only, no capital gain or loss). If you put your money in a fixed interest deposit, you will receive a slightly higher interest rate, because the degree of risk has risen slightly - the term of deposit is longer and you cannot withdraw your money, unlike the cash account or money held as notes and coins. Shares bear a higher risk, because returns vary according to the company’s performance and the state of the economy. The payoff for accepting higher risk is a higher return. International shares are generally slightly riskier than domestic shares, because there is a wider variety of market and country risk.

Asset classes and their features

Asset classReturn

Risk Time horizonIncome Capitalgrowth

Cash Moderate None Low Short

Fixedinterest High Low Low Short-moderate

Australian shares

Moderate High High Long

International shares

Low High High Long

Property Moderate Moderate Moderate Long

Other investments*

Low High High Long

* e.g. precious metals, hedge funds, derivatives

Source: ANZ Bank

In personal financial planning, it is important to consider how much risk you can bear! Are you a risk seeker, or a risk avoider? You need to be comfortable with the amount of risk you’re taking on. Some investors are relaxed if their account balance rises and falls, while others become nervous. As investment advisers say, you have to be able to sleep at night! Several factors might affect your attitude to risk, such as your reasons for investing (growth or security); your time frame (how long can you hold your investment); your knowledge and experience in investing; and your age and background.

The importance of timeAccording to the ‘fido’ web site [source: www.fido.gov.au] a single person needs accumulated

savings of about $460,000 to produce the annual income of $38,400 required for a ‘comfortable’ lifestyle. The question is how long does it take to build such a ‘nest egg’? The answer is that a single person on an average income will take most of their working lives to accumulate this wealth in their superannuation account (although they may also have other investments such their own house).

Time is crucial in personal investment, for two reasons. Firstly, time magnifies the effect of compound interest - it allows interest to earn more interest. As can be seen from figure 4.2 (see next page) a $100,000 investment earning 6 per cent per annum takes 12 years to double from $100,000 to $200,000 but will double again to $400,000 12 years after that. Note the impact of an extra two per cent interest rate on the initial investment over the 25 year period.

Secondly, time tends to average out the fluctuations that can occur in investment returns. An investment can have good and bad years due to economic forces or events in the market

RETURN

RISK

Growth

Moderate / balanced

Defensive / conservative

Cash

VOLATILITY and

RETURN

MINIMUM TIME HORIZON

Growth 5+ years

Moderate / balanced 5 years

Defensive / conservative 3-5 years

Cash 1-3 years

Figure 4.1 The risk / return relationship

Cash assets and bank accounts are low risk, but they also provide investors with low returns. Growth assets, where investors target capital gain more than recurring gain (e.g. shares, property) are higher risk, but also offer the promise of higher returns. Defensive or conservative assets, as the graph shows, are medium risk / medium return. Balanced, or moderate growth assets offer higher returns, but carry more risk.

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and company. Most investments in property and shares should be held for 5-8 years for this reason. As figure 4.3 shows, although BHP shares have increased in value considerably in the period shown (1968-2009), there have been periods of rise and fall. Shares bought in December 1969, for example saw a considerable capital loss for five years. On the other hand, buying in December 1982 saw shares double in one year, then fall before rising to nearly three times their purchase price. Had you bought 1000 BHP shares every time their value fell by 10%, your ingoings ($42,000) would be worth in excess of $700,000! (as at June 2010),

A personal investment portfolioThe basic problem of economics is how to achieve as many wants as you can with the

resources you have at your disposal. Financial planning is about trying to build assets for the future with the limited income you have today. For most people, it makes sense to have a portfolio of financial assets. The term portfolio refers to the mix or collection of financial assets you hold.

Why do you need a mix of assets? Couldn’t you just buy lots of shares in one company? Certainly, had you bought shares in a company such as BHP, your returns over time would

be handsome. But not all companies survive and grow - on average about 10 companies are delisted from the ASX every year, in which case investors lose most of their money.

As a result, most advisers recommend that people should think of their financial plan as a pyramid (as shown in figure 4.4). The base is the widest of the four levels of the pyramid. Your financial plan needs to have a secure base with assets which provide insurance against the events that many of us are likely to face. For someone currently aged 35, the chances of experiencing a disability which prevents work for a three-month period over the next 30 years is 65%. For 45 year-olds, the chance is 44%. It makes sense, therefore, that the base of the financial pyramid should be designed for preservation of capital. The term ‘preservation’ means that your assets just keep pace with inflation over time.

Once you have a base for your plan, you can commence the saving part, using regular savings, contributions to superannuation and paying off a housing mortgage.

The third level of the pyramid is the growth element - as soon as you are able, you should begin to invest in growth assets such as shares and property. Growth portfolios also attempt to strike a compromise between long-term growth and current income. The ideal result is a mix of assets that generates cash as well as appreciates over time with small fluctuations in the value of the principal. In bull markets (rising share prices), growth portfolios tend to outperform other portfolios; in bear markets (falling prices), they may fall in value.

Finally, the top level of the pyramid, ‘risk’, suggest that a small proportion of funds should be invested in speculative assets that offer the chance of high returns, as long as the holder can bear the chance of losing that part of their investment.

DiversificationAs an old saying goes, ‘never put all your eggs in one basket’. Imagine having all your

savings invested in one company! If the company went broke, your investment would be worthless. Following this logic, you should aim to diversify (spread) your financial assets - both across and within financial asset classes (e.g. three mining shares, three banks). Diversification means investing your money across a range of different investments to reduce risk. The exact mix of investments you choose depends on your objectives, the amount of time you have available, and your personal tolerance for risk. Diversification is important because no single type of investment consistently performs better than others. They all have their ups and downs. Owning a diverse range of investments means that although you might not get the best available return, neither should you get the worst return.

PROTECTION

GROWTH

SAVINGS

RISK

Regular savings; superannuation; purchasing a home

Life insurance; income protection; disability insurance; emergency funds; wills; debt reduction

Share portfolio; investment property; other growth assets

Speculation

Figure 4.4 Personal investment pyramid

1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 250

100000

200000

300000

400000

500000

600000

700000

$

Years

$429,187

$684,848

$255,660$100,000 compounded at 8% p.a.

$100,000 compounded at 6% p.a.

Figure 4.2 The impact of time

1968

1969

1970

1971

1972

1973

1974

1975

1976

1977

1978

1979

1980

1981

1982

1983

1984

1985

1986

1987

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2000

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2002

2003

2004

2005

2006

2007

2008

2009

0

500

1000

1500

2000

2500

3000

3500

4000

4500

1969 $5.001970 $4.251971 $3.801972 $3.241973 $2.701974 $2.031975 $1.28

at December 31

1982 $1.581983 $3.601984 $2.461985 $4.221986 $4.27

at December 31

Source: BHP website

Figure 4.3 BHP share price 1968-2009

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Learning activity 4.5 DiversificationImagine you had enough money to invest in 12 apartments in the city. Would you buy all apartments in the same block, or would you buy in different locations? Explain your answer. What other types of asset should be diversified?

Diversification is a proven strategy that has been used successfully by generations of investors. All professional investment managers use diversification as a means of reducing risk. In the share market, it is thought that the appropriate level of diversification is to have 12-14 different shares in your portfolio.

Investment portfoliosNow that we have introduced the basic investment concepts, we can state a key financial

planning recommendation: invest your money for the long term in a diverse portfolio of assets which provide a balance between risk and return.

Of course, how you develop your portfolio depends upon your personal circumstances and your attitude to risk. A good illustration of the portfolio concept is the way professional fund managers set portfolios for the pooled funds of their clients. In many investment ‘products’, investors have choices of funds, such as:

• capital stable - aiming to achieve 2 per cent above inflation over a 2 - 4 year period• balanced - aiming to achieve 3 per cent above inflation over a 3 - 5 year period• growth - aiming to achieve 4 per cent above inflation over a 5 - 7 year period• high growth - aiming to achieve 5 per cent above inflation over a 8 - 10 year periodThe table below shows how one major Australian superannuation fund allocated its

members’ funds across cash, fixed interest, Australian shares, international shares and other investments.

Asset / portfolio Capital stable Balanced Growth High growthCash and fixed interest 70.0 30.0 15.0 0.0Australian shares 11.0 32.5 36.5 46.0International shares 6.5 17.5 23.5 24.5Property 12.5 12.5 12.5 17.0

Alternative investments 0.0 7.5 12.5 12.5

Had a member of this fund had invested in a balanced portfolio, 30 per cent of their funds would be invested in cash and fixed interest securities. As we have seen, these are safe, but offer low returns. A ‘high growth’ investor, on the other hand, has none of their funds directed into cash, and a large proportion is invested in riskier assets.

Learning activity 4.6 Investment portfoliosRead the table on the previous page. Prepare a pie graph which shows the asset allocation of ONE of the portfolios. Label your graph accurately. If you chose the balanced fund, the 30 per cent in cash becomes 30 per cent of the circle (108 degrees).

Given your age and attitude to risk, which portfolio would you choose? If you were ar risk-averse 55 year-old, which portfolio should you choose? Explain.

Evaluating investmentThe term ‘evaluate’ means to decide whether a course of action or decision is worthwhile. To

evaluate an investment, we investigate an asset’s return, risk, liquidity and volatility. As we have seen, the returns on a financial asset are made up of recurring and capital gains.

Recurring gains are interest and dividends paid to holders of assets on a regular basis. Capital

returns refer to the growth in the value of the asset. In figure 4.4, the returns to the holders of the various classes of financial asset between 1997 and 2007 are compared. Australian shares achieved a 13 per cent return on average over this period, just out performing the return on property investment companies listed in the sharemarket.

Learning activity 4.7 Two portfolios

Asset Susan Shirley Two investors, Susan and Shirley, have investment portfolios described by the table at left.

Which woman has the more conservative portfolio? Explain.

Which woman should hold their portfolio for longer? Explain.

Cash 30 20Fixed interest 20 10Australian shares 25 35International shares 20 28Property securities 5 7

100 100

Of the four portfolios shown in learning activity 4.8, the high growth assets are the most volatile - the returns have the greatest range (difference between high and low), or volatility.

Learning activity 4.8 Investment returns

Portfolio performance (% return p.a.) The table shows the performance of various types of portfolio in the Australian superannuation fund discussed on page 36.For each asset type, calculate the range of returns i.e the difference between the highest and lowest return, and the average annual return over the five years.

You invested $100,000 in a balanced investment portfolio in 2005. Calculate how much your portfolio will be worth at the end of 2009.

CS B G HG 2009 0.9 12.7 12.7 -14.5 2008 0.3 -8.2 -8.2 -10.2 2007 8.5 17.5 17.5 20.9 2006 7.8 17.4 17.5 21.1 2005 9.7 17.5 17.4 16.6

Liquidity is an important consideration in personal investment planning. The term refers to the ease with which an asset can be converted to cash (i.e sold). Fixed interest securities and

0

2

4

6

8

10

12

14

0

2

4

6

8

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12

14

Source ASX

Grossreturn

After tax atlowest tax rate

After tax athighest tax rate

Australian shares

Residentialinvestment

property

Australian listed

property

Fixednterest Cash

% p.a. av 1997 - 2007

Figure 4.4 Asset returns 1997-2007

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investment such as fixed deposits cannot be sold until the end of the nominated period e.g. a six month fixed deposit locks away your money for six months. A property in your portfolio may take some time to sell, depending on its location and the state of the property market. The average sale time even in a booming market can be 12-14 weeks. It is appropriate to have a proportion of your assets in fairly liquid form - able to be sold fairly quickly should the need arise. A well structured portfolio should automatically achieve this at the base of the pyramid.

Shares or property?One of the biggest investment questions is whether to invest in shares or property (although

a balanced portfolio should have some of each). The term ‘direct property’ refers to a house or apartment you own and rent out whereas ‘indirect property’ means buying shares in companies that invest in property (usually commercial and industrial buildings). Property is also regarded as a long-term investment because values increase slowly over time. There are two ways a property can create wealth:

• the value of the property increases (i.e. capital gain)• income is generated from rental returns (i.e. recurring gain)The advantages of property investment are that it is a fairly secure, long-term investment. Many

people are attracted to property because it is a solid, visible asset. Like every financial asset, owning property has expenses and uncertainties. For direct investment, there are significant purchase costs, plus legal costs, stamp duty, property inspection fees, maintenance, rates, body corporate fees and insurance. Depending on the state of the economy and population trends, the rental return may not meet your expectations, or value of the property may decline (although this is rare in Australian capital cities). Property can be difficult to sell when it comes time to liquidate your asset (convert the asset to money).

Shares are also a long-term investment, although gains (or losses) can occur quickly. There are two ways that investments in shares can create wealth:

• the value of the underlying share increases (i.e. capital gain)• dividend income is generated from profits (i.e. recurring gain)Shares are a little riskier than property, for several reasons. The value of a share is driven by

expected future profits, so anything that affects profitability may impact on the share price. This can be at individual share level, or at ‘macro’ level - events in the whole economy.

Shares have fewer holding costs, although it is unwise to ‘forget’ them. An advantage of shares over property is that they are generally highly liquid (they can be bought and sold fairly quickly on the stock market) because each public company has many thousands of shares. As the following table shows, there have been several periods in the last 40 years in which there was a reversal of share prices - a bear market. This illustrates again that most investors need to diversify and invest for the long period, and only after they have a base for their pyramid.

Learning activity 4.9 Share market reversalsThe following table shows the extent of the fall in the All-Ordinaries Index on the Australian Securities Exchange for nine ‘bear market’ periods between 1970 and 2010.

Period % decline Period % decline

Jan1970-Nov1971 -39 Sep1989-Jan1991 -32

Jan 1973 - Oct 1974 -59 Jan 1994 - Feb 1995 -22

Aug1976-Nov1976 -23 Mar 2002 - Mar 2003 -22

Nov1980-July1982 -41 Nov2007-Mar2009 -55

Sep1987-Nov1987 -50 Source: Australian Financial Review, March 6-7 2010

Calculate the average percentage fall over the periods of bear market listed above. In which period was the decline in the market most rapid?

Behavioural financeEconomics assumes that people make decisions in an entirely rational way – by collecting

all the relevant data, analysing it fully, and weighing up the costs and benefits of each choice before they decide on a course of action. Rational means to act ‘scientificallly’, avoiding emotion. In real life, this is unlikely. For a start, people have different objectives (like wealth or security) and different attitudes (some people, for example, seek risk; some avoid it). Secondly, we all face the problem of incomplete information – we don’t have all the information on which to make a rational decision. Thirdly, even if we had all the information, we suffer limited ability (mental processing power) to cope with it all. Fourthly, personal investors face emotional and psychological biases like fear, greed and peer group pressure. And finally, financial planning is dealing with the future, and we tend to make decisions about the future based on what we knew from the past - not necessarily an accurate measure.

All of this means that people are not ‘wired up’ to be smart investors who get all decisions right, especially when the market is volatile. In the last stockmarket downturn in 2008, for example, many people sold shares as their value fell, fearing they would fall further. Was this the right thing to do?

Trying to understand how people make financial decisions has become a huge research area in the last twenty years, and a number of interesting ideas have emerged. A full examination of behavioural finance is beyond the scope of this book, but it is interesting to note a couple of ‘anomalies’ (something unusual or strange) to illustrate how psychology can affect decisions.

Learning activity 4.10 Behavioural finance experiments1. You are approached in the street and offered two choices:

A – a 50% chance of winning $5 and 50% chance of nothing, or

B – a 75% chance of winning $10 and 25% chance of losing $5.

Which choice would you make? A or B? Why? Ask this question of thirty students. Record your results carefully.

2. Consider a choice of A or B, where A yields a 3/4 chance of winning $6,000 and 1/4 chance of zero, while B yields a certain gain of $4,000. Which will you choose?

3. When one petrol station advertises a ‘3% surcharge for credit’, and the one down the street advertises a ‘3% discount for cash’, how will motorists react?

Restaurant A advertises ‘early-bird’ specials or discounts. Restaurant B uses a peak-period ‘surcharge’. The prices, however, are the same. How much will customers react to each offer?

You should find that most people in experiment 1 choose A because they wish to avoid the pain of a $5 loss that could happen if they chose B. In fact, they would be better to select B (the ‘expected value’ based on probability is $6.25). This anomaly is called ‘loss aversion’, and points out that people react more to losses than gains: the pain of loss weighs more heavily on our thoughts than the pleasure of gain. This is also illustrated by experiment 2 - the logical choice is A. Probability suggests you should end up with 0.75 x $6000 = $4500 - higher than the certain $4000. Three quarters of people select B - they exhibit risk averse behaviour.

What is the expected value of an investment or a gamble? It is the average value of the likely payoffs of a decision taking into account the probability of each payoff. For example, suppose you win $1 if a coin toss lands heads and lose $1 if it lands tails. The expected value of this gamble is 0.5 ($1) + 0.5 (-$1) = 0. When the expected value of a gamble is zero, it is called a fair gamble. A person who refuses a fair gamble is called risk averse – in other words, they are afraid of risk. An outcome with a positive expected value is a ‘better than fair gamble’. For example, a coin toss in which you win $2 on heads and lose $1 on tails has an expected value of 0.5 ($2) + 0.5 (-$1) = $0.50. Some risk averse people would even refuse to accept this gamble!

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Everyday Economics

Another anomaly is called framing. People make different choice when the information is presented in different ways. In experiment 3 in learning activity 4.10, people react more positively to the discounts, even though the offers are the same!.

Another anomaly is regret! Many investors consider the possibility that they will regret their investment decisions. Regret can motivate one investor to take more risks because she would regret not doing so if the price of securities increases a great deal, or it may motivate another investor to be more risk averse because he would regret buying an asset if the price drops significantly.

The point of this research is not to find ways of making people more ‘rational’ decision-makers, but to understand how they behave in certain circumstances and make better information available to them.

Chapter review questions....

Multiple choice questions For each of the following questions, choose the best alternative.

1. The ability to understand money and how to manage it is called a. financialliteracy. b. budgeting. c. gross income. d. financialplanning.

2. Therelationshipbetweenriskandreturninpersonalfinanceassetsis a. negative - as risk rises, returns tend to fall. b. negative - as returns, rise, risk tends to fall c. positive-asriskrises,sodopotentialreturns d. uncertain - they may not be related at all.

3. Whichofthefollowingpersonalinvestmentportfoliosismostsuitableforanelderlyinvestorwhohasjust retiredfromwork? a. agrowthportfolio b. acapital-stableportfolio c. adiversifiedportfolio d. acashportfolio.

4. Whichofthefollowingassettypesshouldformthebaseofthepersonalfinancialpyramidformostpeople? a. insurance and savings assets b. risk and growth assets c. protectionandgrowthassets d. protectionandriskassets.

5. Behaviouralfinanceresearchhassuggestedthatpeopleare a. rational b. incapableofmakingtherightdecisions c. subjecttotheinfluenceofpsychologyontheirdecisions. d. irrational.

Questions

Try to write a half page on the following topics. Good answers will be clear, logical, use appropriate terms and relevant examples. Try to be unbiased. Do not give opinions unless you can justify them.

1. Describe the objectives of personal financial planning.

2. Using the financial pyramid, describe the characteristics of a ‘good’ personal finance plan.

3. Describe, using example from various asset classes, the relationship between risk and return in finance.

4. Explain how time is an important variable in personal financial planning.

Governments in advanced economies have several responsibilities. One of these is the redistribution of income and wealth from the rich to the poor. The methods the government uses to achieve their objective (a minimum standard of living for all) has a significant impact on our personal income and spending. This chapter introduces some of the concepts that help us understand how the government achieves its objective, and will:

• explain the concept of redistribution of income• explain the sources of government revenue and the way it spends these funds• outline the ways in which governments provide income support, and the impact of that

support on incomes and wealth• describe the ways in which governments seek to protect consumers• describe ways in which governments support long term personal investment.

Income and wealthIn 2009-2010, Australia’s Gross Domestic Product (GDP) will exceed $1.05 billion The GDP

is the total value of all final goods and services produced in the country over the course of a year. In June 2010, it is estimated that the total wealth of the nation will exceed $10 trillion (10 million million)

Income refers to regular and recurring cash receipts to a household from sources such as wages, salaries, government assistance or business profits. As shown in figure 5.1, Australia’s income distribution is skewed. In 2007-08, the average household earned $811 per week. Only a few per cent of households earned above $1400 per week. This skewed pattern of income distribution patterns is typical of all developed economies.

Wealth is defined by the Australian Bureau of Statistics (ABS) as the difference between a household’s assets and its liabilities. Household assets are generally held as property, shares, motor vehicles, savings and superannuation while liabilities include mortgages, personal loans and credit cad debt. People seek wealth - it means they feel secure economically, provides

The role of government

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