Discussion / Answer 2 questions and comment on 2 students / 200~300 words for answers / need in 6 hours

Open Posted By: ahmad8858 Date: 15/10/2020 Graduate Research Paper Writing

Question 1:

From Ch. 11.   List some of the types of risks to human assets and briefly explain how to reduce them.

Student 1:

Human assets, also referred to as human capital is an intangible asset   It can be classified as the economic value of a worker's experience and skills. It includes assets like education, training, intelligence, skills, health, and other things employers value such as loyalty and punctuality.

There are risks to human assets. And there are some possible ways to migrate the risks. First of all, there is a threat to the human itself. He can use diet, exercises, stress management to reduce the risk. In case of illness, he can buy medical insurance, public and private disability insurance to reduce the risk. In case of early death, of course, life insurance, diet, exercises will reduce the risk, while in case of extra long life, he can use precautionary savings, social security, government Medicare and private medical insurance to reduce the risk. There is the risk of lower income and layoffs. In this case, he can save up his precautionary savings, use the government unemployment benefits and find another job to secure household earnings.

There are also a few human assets related risks, for example, the integrity of the personal assets. In this case, he can diversify his retirement savings and buy inflation protected securities.


Altfest, L., (2017), Personal Financial Planning, 2nd ed. McGraw-Hill. 

Human capital. Retrieved from  https://www.investopedia.com/terms/h/humancapital.asp 

Question 2:

From Ch. 10.  What kinds of investments are best suited to saving for the down payment on a house to be made in three years? Explain.

Student 2:

There's multiple forms of investments that would be suitable for saving for a down payment on a house in three years time. The investments would be mutual funds, bonds, and conservative stocks. Personally, I wouldn't choose conservative stocks just because even if investment professionals deem the stocks safe, you truly never know what could happen. Look at what happened back in March at the beginning of COVID, I'm sure most people didn't see the crash that took place coming. However, I think mutual funds and bonds are both perfectly fine options. Mutual funds investment decisions are made by the shareholders and aim to keep a diversified portfolio, while still being professionally managed. This is a nice and fairly safe option to save your money while most likely receiving a nice return back as well. Bonds are a nice and most likely safer option than mutual funds. Bonds are basically a loan to a government, usually at a predetermined length of time, where if you cash it in you will receive what you paid back with interest. As long as the bond is with a creditworthy government or association, bonds are known to be super safe. If you're able to get bonds in 1, 2, or 3 year increments, I would say bonds would be my choice for saving for the down payment. 


Rosenberg, Eric. “Saving for a Down Payment: Where Should I Keep My Money?” Investopedia, Investopedia, 28 Aug. 2020, www.investopedia.com/articles/investing/092815/where-should-i-keep-my-down-payment-savings.asp.

Category: Engineering & Sciences Subjects: Electrical Engineering Deadline: 12 Hours Budget: $120 - $180 Pages: 2-3 Pages (Short Assignment)

Attachment 1

Second Editin


Lewis J. Altfest

Personal Financial Planning


Block, Hirt, and Danielsen Foundations of Financial Management Sixteenth Edition

Brealey, Myers, and Allen Principles of Corporate Finance Twelfth Edition

Brealey, Myers, and Allen Principles of Corporate Finance, Concise Second Edition

Brealey, Myers, and Marcus Fundamentals of Corporate Finance Eighth Edition

Brooks FinGame Online 5.0

Bruner, Eades, and Schill Case Studies in Finance: Managing for Corporate Value Creation Seventh Edition

Cornett, Adair, and Nofsinger Finance: Applications and Theory Third Edition

Cornett, Adair, and Nofsinger M: Finance Third Edition

DeMello Cases in Finance Second Edition

Grinblatt (editor) Stephen A. Ross, Mentor: Influence through Generations

Grinblatt and Titman Financial Markets and Corporate Strategy Second Edition

Higgins Analysis for Financial Management Eleventh Edition

Kellison Theory of Interest Third Edition

Ross, Westerfield, Jaffe, and Jordan Corporate Finance Eleventh Edition

Ross, Westerfield, Jaffe, and Jordan Corporate Finance: Core Principles and Applications Fourth Edition

Ross, Westerfield, and Jordan Essentials of Corporate Finance Ninth Edition

Ross, Westerfield, and Jordan Fundamentals of Corporate Finance Eleventh Edition

Shefrin Behavioral Corporate Finance: Decisions that Create Value First Edition

White Financial Analysis with an Electronic Calculator Sixth Edition


Bodie, Kane, and Marcus Essentials of Investments Tenth Edition

Bodie, Kane, and Marcus Investments Tenth Edition

Hirt and Block Fundamentals of Investment Management Tenth Edition

Jordan, Miller, and Dolvin Fundamentals of Investments: Valuation and Management Seventh Edition

Stewart, Piros, and Heisler Running Money: Professional Portfolio Management First Edition

Sundaram and Das Derivatives: Principles and Practice Second Edition


Rose and Hudgins Bank Management and Financial Services Ninth Edition

Rose and Marquis Financial Institutions and Markets Eleventh Edition

Saunders and Cornett Financial Institutions Management: A Risk Management Approach Eighth Edition

Saunders and Cornett Financial Markets and Institutions Sixth Edition


Eun and Resnick International Financial Management Seventh Edition


Brueggeman and Fisher Real Estate Finance and Investments Fifteenth Edition

Ling and Archer Real Estate Principles: A Value Approach Fourth Edition


Allen, Melone, Rosenbloom, and Mahoney Retirement Plans: 401(k)s, IRAs, and Other Deferred Compensation Approaches Eleventh Edition

Altfest Personal Financial Planning Second Edition

Harrington and Niehaus Risk Management and Insurance Second Edition

Kapoor, Dlabay, Hughes, and Hart Focus on Personal Finance: An active approach to help you achieve financial literacy Fifth Edition

Kapoor, Dlabay, Hughes, and Hart Personal Finance Eleventh Edition

Walker and Walker Personal Finance: Building Your Future Second Edition

The McGraw-Hill/Irwin Series in Finance, Insurance, and Real Estate Stephen A. Ross Franco Modigliani Professor of Finance and Economics Sloan School of Management Massachusetts Institute of Technology Consulting Editor

Second Edition

Personal Financial Planning

Lewis J. Altfest, Ph.D. Pace University


Published by McGraw-Hill Education, 2 Penn Plaza, New York, NY 10121. Copyright © 2017 by McGraw-Hill Education. All rights reserved. Printed in the United States of America. Previous edition © 2007. No part of this publication may be reproduced or distributed in any form or by any means, or stored in a database or retrieval system, without the prior written consent of McGraw-Hill Education, including, but not limited to, in any network or other electronic storage or transmission, or broadcast for distance learning.

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ISBN 978-1-259-27718-4 MHID 1-259-27718-6

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Certified Financial Planner Board of Standards, Inc., is a professional regulatory organization based in the United States of America that fosters professional standards in personal financial planning so that the public had access to and benefits from competent and ethical financial planning. They can be reached at (800) 487-1497, or on the Web at www.cfp.net. CFP® Certification Exam Questions © 2014, 2004, 1999, 1996, 1994 CFP Board. Used with permission.

All credits appearing on page or at the end of the book are considered to be an extension of the copyright page.

Library of Congress Cataloging-in-Publication Data

Altfest, Lewis J., author. Personal financial planning/Lewis J. Altfest. Second edition. New York, NY: McGraw-Hill/Irwin, [2017] LCCN 2015035267 ISBN-13: 978-1-259-27718-4 (alk. paper) ISBN-10: 1-259-27718-6 (alk. paper) LCSH: Finance, Personal. Financial planners. LCC HG179 .A4484 2017 DDC 332.024—dc23 LC record available at http://lccn.loc.gov/2015035267

The Internet addresses listed in the text were accurate at the time of publication. The inclusion of a website does not indicate an endorsement by the authors or McGraw-Hill Education, and McGraw-Hill Education does not guarantee the accuracy of the information presented at these sites.


To my wife, Karen. Her success as a financial planner after receiving a Ph.D. in an unrelated field made her inputs particularly valuable in constructing this text and its second edition. Perhaps more importantly, through her ability to balance a career and dedication to our children and the quality of our lives together, she created an environment that made this book possible.


About the Author Lewis J. Altfest, Ph.D., CFP, CFA, CPA, PFS Lewis J. Altfest has balanced a career in financial planning and investing with one as an associate professor of finance. He began as an accountant working for a then “Big 8” accounting firm and became a Certified Public Accountant. After some shorter-lived ventures, he joined the Wall Street firm of Wertheim and Co. in its investment research department. He held similar positions with Lehman Brothers and Lord Abbett & Co. At Lord Abbett & Co., an investment management firm, he rose to become Director of Investment Research, Chief of Long Range Strategy, and a general partner of the firm. At the same time, he began seriously pursuing a Ph.D. and teaching part-time. It was at Lord Abbett that Lewis Altfest decided to focus on helping individuals instead of institutions. He wanted to become the “Consumer Reports of Financial Planning,” that is, to provide unbiased financial and investment advice and to dedicate himself to instructing students and the public on financial matters. In 1982, he established a financial planning and investments firm along with another individual and in 1983 incorporated a firm performing activities by himself. At about the same time, he joined the faculty of Pace University as Associate Professor of Finance. His wife, Karen C. Altfest, joined him in business shortly thereafter (his son some 20 years later), and together they have established a nationally recognized multi-person financial and investment advisory firm, Altfest Personal Wealth Management Inc., located in New York City. Dr. Altfest has been active in financial planning industry matters for over 30 years, in- teracting with other planners nationwide, and has been an original member and a member of the board of directors of the National Association of Personal Financial Advisors and served on the board of directors of the IAFP New York Chapter, the predecessor of the Financial Planning Association, and on the board of the Educational Foundation of NAPFA as well. He was named one of NAPFA’s 30 most influential advisors in 2013. Over the past 30+ years, Dr. Altfest has been named to Best Planners in the United States lists by Money magazine, Worth Magazine, Mutual Funds Magazine, and Medical Economics. Over the past 10 years and again in 2014 Barron’s named Dr. Altfest one of the “Top 100 Independent Financial Advisors in the Nation.” In 2014, he was inducted into Research magazine’s Hall of Fame, and Dr. Altfest’s firm was named by Financial Times magazine as one of the Top 300. In 2014, he received The Best Practices Award Recognizing Altfest Personal Wealth Management as a Best Managed Firm by Investment News. He has been included among Bloomberg’s “Top Wealth Managers.” He was also awarded the Lifetime Achievement Award by Financial Planning magazine. At Pace University, he has been active in many pursuits, including serving on the University’s employee benefits committee, chairing the Lubin School’s Graduate Division tenure committee, and chairing the finance department’s recruitment and tenure committees. He has published academic research papers in financial planning and investing and has two other books, Introduction to Business (Harper and Row), and Lew Altfest Answers Almost All Your Questions about Money (McGraw-Hill), which he co-authored with his wife. Dr. Altfest participates in many professional and academic associations today, includ- ing the FPA, NAPFA, CFA Institute, and AICPA, and is an original member of the Academy of Financial Services. His advice and research have been quoted in such media as The New York Times, The Wall Street Journal, Newsweek, US News and World Report, Fortune, BusinessWeek, Money Financial Advisor, Financial Planning, Investment News,

About the Author vii

Bloomberg Wealth Manager, and Bottom Line, and he has written a monthly column for Medical Economics for over a decade. He has appeared on CBS, ABC, NBC, CNN, CNBC, and others. For his role in the development of the financial planning profession, the Business and Economics Alumni Society of the City College of New York chose Dr. Altfest as their 2006 Career Achievement Award recipient. Baruch College, the then undergraduate division of City College of New York, provided him with the Alumnus of Distinction Award in 2012. He has been named an Alumnus of the Year by CUNY Graduate Center Alumni Association, where he received his Ph.D. degree. You can catch him on Saturdays and Sundays relaxing on the deck of his weekend home, alternately doing work, talking to Karen, and gazing at the birds in the treetops, which one of his clients assured him would add years to his life.



GOALS OF THE BOOK Personal Financial Planning is designed to be used for the study of personal finance and financial planning from a planner’s perspective. This text goes beyond the traditional per- sonal finance texts to teach students how to do actual financial planning and integrates the theory and practice of personal finance. This book incorporates a theory of personal financial planning that demonstrates the similarities and differences between personal and business finance and integrates the entire body of financial material presented. It is intended to utilize the theoretical contri- butions over the past half-century, particularly modern portfolio theory, to elevate the level of presentation. At the same time, its goal is to remain easy to understand and use- ful in real life. Instructors of education courses, whether for general or CFP® certification prepara- tion purposes, may consider the text’s practical combination of planning facts, analysis, and frequent step-by-step instructions attractive. Experienced financial planners and other professionals looking for a one-volume reference to the planning field from a prac- titioner’s perspective, or who may be considering pursuing the Certified Financial Planner™ (CFP®) certification should also find the book appealing. Those who would like to plan their own financial future in a comprehensive way also should find the text informative.

THEMES This text is unified by a few themes. One is that the household resembles a business and can profitably use its financial techniques. Another is that decisions for the household, for you, include all operations and all assets and obligations. In other words, decisions are ultimately made on an integrated basis. Whether we are engaged in investment activities or mapping retirement plans, we are performing household operations that fall under personal financial planning’s mandate. Our personal financial planning objective is effective household operations that we achieve through logical, businesslike financial procedures. Households whose activities are financially efficient have the foundation for personal goal achievement. This approach is covered in more detail in Chapter 4.

ORGANIZATION In keeping with its practical emphasis, Personal Financial Planning is largely ordered around the parts of a financial plan. Its parts all funnel into the final section, Integrated Decision Making. The approach is illustrated in Figure A. Many of the chapters that require active planning use a full or modified process- oriented approach that takes the student through the methodology point by point. This approach not only provides an easy-to-follow structure; it also better prepares financial planning majors for more advanced material to come.

Preface ix

Content Personal financial planning is an unusually broad discipline that requires knowledge of topics ranging from mathematics to human interaction. Not coincidentally, there is an introductory chapter in Part One that presents virtually all the mathematical material needed in simple fashion with solved examples for each step. It is a feature of the book that all new concepts are followed by examples using generic calculator solutions where possible and Excel-based solutions in the text and on the website. The human side of the process, which is often overlooked, is presented in Chapter 3 in the sections that stress communications and goal setting. Human actions are expanded on in a separate chapter, “Behavioral Financial Planning” (Chapter 18), which presents the latest thinking on the topic. Practical examples of its contributions are given in each major area of personal financial planning. In keeping with the practical nature of the text there is a final chapter, “Completing the Process,” that truly explores the finishing process. To the author’s knowledge, this is the only textbook to cover PFP integration and overall decision making in detail. The chapter could have been called simply “Completing the Financial Plan.” However, it essentially does more, indicating how certain tools and practices demonstrate the comprehensive na- ture of PFP and improve the completion process. It is this integration that requires overall decision making that differentiates personal financial planning from personal finance and from other professions that offer financial advice. Personal finance and investments courses alike tend to treat financial investments as the centerpiece of investment material. There are other assets, namely human-related and real assets, that importantly enter into decision making. In Chapter 8, “Household Investments,” these investments, often given less emphasis, are described and analyzed in detail. The text has one review chapter in Part Six, “Planning Essentials.” Chapter 16, “Stocks, Bonds, and Mutual Funds,” provides those without a proper background, or students in need of a review, with a quick upgrading in usable knowledge in investment categories. Included is descriptive material on stocks, bonds, mutual funds, and exchange-traded funds.

VII Integrated Decision


I Planning Basics

II Ongoing

Household Planning

III Portfolio


VI Planning


IV Specialized


V Tax and Estate


FIGURE A Sections of the Book

x Preface

Normal Financial Coursework and CFP® Preparation Current or possible future CFP® candidates can receive credit toward CFP® requirements in a regular financial planning course.1 Personal Financial Planning provides all the specific material necessary to comply with CFP® required content areas. It is an appropri- ate method of presentation for all students, not just financial planning majors. Its emphasis on practical material, theory, case study analysis, and “how to do it approach” provides a broader experience for both one-time students and those headed for CFP® status. Professors who desire further descriptive coverage, including those who prefer enhanced CFP® certification preparation information, will find special chapters for that purpose as well. Suggested syllabi and outlines are provided for classes: 1) intended solely for students interested in a CFP® and 2) for combined regular survey and CFP® students. This will accommodate all students interested in applying for CFP® credit as detailed in the Instructor’s Manual found on the book’s website.

FEATURES There are a number of features throughout the chapters to help bring the text material to life.

• Chapter Goals The goals of each chapter are stated at the beginning of that chapter. They are most of- ten expressed in action-oriented terms to emphasize the usefulness of the material in daily situations.

• Dan and Laura Opening Case A key feature is the use of a single case study that is developed throughout the text. Each chapter starts with a relevant sentence or two from that chapter’s event. Significantly at chapter’s end, Dan and Laura’s day-to-day problems are stated and an- swered from a financial planning practitioner’s point of view. This ongoing case study also reviews the chapter’s material and places it in a broader context. The case permits the student to understand how the chapter’s material can be applied to real-life situa- tions and experience the information-gathering process as a professional interviewer would. Reviewers have said that this case study, which is deeper than a typical academic one, is more interesting and closer to a student’s own experiences.

• Real-Life Planning Almost every chapter starts with a minicase called “Real-Life Planning.” It sets the stage for the educational material to follow. Students have found these “stories,” largely based on the author’s own experiences with clients and told in a nontechnical manner, an interesting, easy-to-relate-to way to begin the chapter.2

• Key Terms Key words are presented in boldface to highlight terms and concepts that are emphasized.

• Practical Comments Practical Comments are often used to underscore the situations in which real human actions differ from the way the book tells you it should be done. These highlighted

1 The course must comply with coverage of CFP® required areas. If it does the student can receive credit

toward eligibility for the exam and the CFP® within a normal academic curriculum without it being taken

through a CFP® Board-Registered Program. “The CFP® Board will consider granting credit toward the educa-

tional course work requirement for CFP® certification if: 1. You can submit documentation that you have

successfully completed equivalent approved upper division level college or university coursework at a

regionally accredited college or university . . .” See CFP® Board education requirement for further details—

http://www.cfp.net/become-a-cfp-professional/cfp-certification-requirements/education-requirement. 2 Certain material has been altered in part to protect the identities of the people who are discussed.

boxes’ recommendations, given to meet the issues at hand, carry the tone of a financial planner who has dealt extensively with these circumstances.

• Tables and Figures Tables and figures have been placed throughout the text. Wherever useful, the tables have presented a summary of factual material in an easy-to-refer-to manner.

• Examples As we mentioned, there are many examples given, particularly in mathematical and more-difficult-to-describe concepts. Special efforts are made to provide an answer for every type of problem, often including an explanation of why a particular step is taken.

• Excel and Calculator Examples Excel is explained and solutions are given for all appropriate problems in the appendix to the text and on the website. In addition, calculator solutions are provided on a generic pictorial basis in the body of the text where possible, thereby allowing any financial calculator to be used to solve those problems. Where problems are more complex, key- strokes of two leading calculators, the HP12C and the TI BAII Plus, are illustrated right in the example.

• Comprehensive Financial Plan An actual comprehensive financial plan is provided on the website. It is based on the Dan and Laura case study presented by chapter, but this time in a more compact manner after final decisions have been made. Students should gain an appreciation for how an actual financial plan looks and, together with chapter presentations, how it is developed.

There are many end-of-chapter study tools to be used for self-study and/or homework:

• Chapter Summary The salient points of the chapter are placed here. Together with the goals section and key terms, it can guide the student into a better understanding of the chapter’s points.

• Key Terms List with Page References This feature provides in one place a useful compendium of important terms introduced in the text.

• Websites Selected websites indicate where additional information can be obtained.

• Questions and Problems A select list of questions is presented representing a mixture of factual and evaluative matters. The problems stress mathematical computation as a practical exercise of the chapter’s numerical material.

• CFP® Certification Examination Questions A broad list of former CFP® certification examination questions is provided. These demonstrate selected areas of emphasis for those contemplating taking the exam. They also present many practical questions that require students to demonstrate knowledge of the chapter’s topics.

• Case Application and Questions There is a second case study, called Case Application, that is similar in approach to the first one about Dan and Laura. However, instead of having a solution given in the text, this one is to be prepared and submitted by the student and/or discussed in class.

• Student Financial Plan Instructors who wish to schedule a term project for students doing a financial plan for “clients” can do so. In my experience of over 30 years teaching PFP to matriculating

Preface xi

undergraduate and graduate students, this assignment is very popular. The knowledge derived from the two case studies in each chapter and the full financial plan on the web- site enable students to prepare their plans well.

There are also a Glossary and Suggested Readings at the end of the book.

CHANGES IN SECOND EDITION This book goes beyond the presentation of basic facts to teach people how to perform per- sonal financial planning. Since the first edition, the field has become more sophisticated both from the standpoint of the professionals who offer PFP and the consumers who increas- ingly desire broader and deeper knowledge from their financial advisors. At the same time, the public and many students want practical information presented in easy-to-understand terms that don’t speak down to them. Feedback on the first edition indicated that students felt the book was easy to read. The second edition, as described below, adds new sections and text material that significantly enhances the ease of understanding, practicality, and further relatability to college students and provides a lively new Life Cycle Planning section. It also has a subtle new summary of many chapters done in a partly narrative style.

College Age Case Study and Overall Chapter Review A new third case study, called “College Student Case Study and Review: Amy and John,” has two purposes. The first is to provide college-age undergraduate and graduate students, many of whom have not yet established their own households, with issues and interests they can relate to. It presents Amy and John as students with varying challenges and gives instructions on how to overcome them in appropriate chapters. The second purpose is to present a summary of these chapters, whether used as an introduction to or summation of the key points in the text. This partly narrative summary is set in a simpler and less formal style. Those looking for a simple placing together of the major ideas of the chapter irre- spective of their ages should find this case study highly useful.

Professional Advice This new boxed section presented in many chapters adds more news you can use. It presents recommendations on how to resolve common problems people encounter. It is based on the author’s more than 30 years of experience as a practitioner helping literally thousands of people.

Life Cycle Planning This new section placed at the end of most chapters takes the reader through age-related issues ranging from college days to post retirement. It is presented in an action-oriented style from a practitioner’s standpoint. Its approach is intended to be concise and informal.

New Real Estate Chapter It is clear that interest in real estate, whether it be the home or independent properties, has grown sharply in recent periods. This new Chapter 9, “Real Estate and Other Assets,” presents a simplified description of the topic. It also provides a brief description of other alternatives to stocks and bonds.

Revision of Capital Needs Analysis Chapter Chapter 17, “Capital Needs Analysis,” presents the traditional answer to calculating the amount needed to bring about a comfortable retirement. A new, simpler method for calcu- lating that amount is also given.

xii Preface

Modification of Financial Investments Chapter Chapter 10, “Financial Investments,” shifts practical step-by-step information on selecting investments and constructing a portfolio using mutual funds from the background invest- ments in Chapter 16 and simplifies other technical information. It also provides more at- tention to exchange-traded funds (ETFs), which have grown more popular in recent years.

Updating Financial Planning Taxes, economic circumstances, retirement planning, investments, and insurance alterna- tives are among the areas that have changed since the first edition. Taken together, the financial planning field has grown in numbers and sophistication. These new factors have been reflected in the second edition throughout the book.

SUPPLEMENTS Online Learning Center www.mhhe.com/altfest2e The Online Learning Center contains the following assets, which are password-protected for instructors only:

• Instructor’s Manual. Includes solutions for end-of-chapter questions, problems, and case studies.

• Test bank. Word files containing 30–40 questions, including true-false, multiple choice, and essays, prepared by Aron Gottesman, Associate Professor of Finance, Pace University.

• PowerPoint slides. PowerPoint slides for each chapter to use in classroom lecture settings, created by Aron Gottesman, Associate Professor of Finance, Pace University.

New Second Edition Instructor Material:

• Detailed course syllabus including recommended chapter coverage by individual class session provided by type of student (undergraduate, graduate finance major, non- finance major, CFP® prep, combined regular survey and CFP® prep, simpler approach, adult education).

• Comments and suggestions on introducing and conveying material is given by chapter. The comments are based on the author’s more than 30 years of teaching the course.

• Adjustments to test bank and PowerPoint slides done by author.

Preface xiii


I am grateful to the following professionals who read individual or multiple chapters and offered their helpful comments. They verified facts, pointed out discrepancies, added to the material presented, and otherwise contributed to a more polished product.

Roy Ballentine, CFP®

Ballentine, Finn & Co., Inc.

Janet Briaud, CFP®

Briaud Financial Planning, Inc.

Gayle Buff, CFP®, CFA Buff Capital Management

Alfred C. Clapp, Jr. Financial Strategies & Services Corp.

Larry Copperman Steve Aronoff PC

David Drucker, CFP®

Fieldstone Financial Management Group, LLC

Louis Feinstein Louis I. Feinstein, CPA, PC

Linda Gadkowski, CFP®

Beacon Hill Financial Educators, LLC

Harvey M. Goldfarb All Risk Insurance Agency, Inc.

Gary Greenbaum, CFP®, CFA Greenbaum and Orecchio, Inc.

Roy Komack, CFP®

Family Financial Architects, Inc.

Mary A. Malgoire, CFP®

The Family Firm, Inc.

J. Michael Martin, CFP®

Financial Advantage Inc.

Ed O’Hanlon Kieffer & Hahn LLP

Haseeb Ahmed Johnson C. Smith University

M. J. Alhabeeb University of Massachusetts

Mike Barry Boston College

Conrad Ciccotello Georgia State University

Sheran Cramer University of Nebraska—Omaha

Karen Eilers Lahey University of Akron

Kay N. Johnson Penn State University—Erie

J. Jeffrey Lambert, CFP®

University of California—Davis Extension

Jennifer LeSure IVY Tech State College in Indianapolis

Ann Perkins North Dakota State University

Bruce L. Rubin Old Dominion University

Deanna Sharpe University of Missouri—Columbia

David Sinow University of Illinois

Michael Snowdon The College for Financial Planning

Gene R Stout Central Michigan

Don Taylor The American College

Kenneth M Washer, CFP®

Texas A&M University—Commerce

Glenn Wood Winthrop University

Acknowledgments My personal thanks to all academic reviewers. Each contributed importantly to the final copy. Their knowledge of the material and understanding of what it takes to communicate it effectively significantly enhanced the book.

Acknowledgments xv

Tom Orecchio, CFP®, CFA Greenbaum & Orecchio, Inc.

Morton Price Cowan Liebowitz & Latman

Alan Romm Independent Broker

Bruce Ross, CFP®, CLU, ChFC Ronald Rutherford, CFP®

Rutherford Asset Planning, Inc.

Suzette Rutherford, CFP®

Rutherford Asset Planning, Inc.

Harry Scheyer, CFP®, CPA/PFS Pinnacle Financial Advisors LLC

Bob Veres Inside Information

Henry Wendel, CFP®

Wendel Financial Planner & Investment Advisor

I would like to thank my colleagues at Pace University who assisted me by providing con- structive suggestions, including Michael Szenberg, Ron Filante, Aron Gottesman, Qi Lu, Jouahn Nam, Alan Tucker, and P. V. Viswanath. I am also grateful to my graduate assis- tants over the term of this project. One in particular stands out. Oktay Veliev not only was extremely helpful in production aspects treating the book as if it were his own but was responsible for many of the creative diagrams and software examples. Finally, I am grateful to members of my professional staff. Ekta Patel, Dawn Brown, and Michael Prendergast were of material assistance as were administrative staff members Helen Cummings and Marina Marsillo. However, three others stand out. The first is Karen C. Altfest, who provided a strong contribution in overall advice and chapter reviews. The second is Paul Palazzo, who made a major contribution to the case study and helped in several other areas. Lastly, I want to thank Dr. Abe Fenster for his constructive sugges- tions, pedagogy, and continuing support in the strategy and execution of this book. The second edition benefited importantly from Andrew Altfest, whose assistance in all areas of the book was very valuable. I also received a material contribution from the analytical and updating skills of Don Korn. In addition, members of my professional staff reviewed and made suggestions including Paul Palazzo. Significant contributions were made by Dawn Brown, Boyan Doytchinov, Brett Fry, Steven Cadoff, and Brendan McEwan. Dr. Abe Fenster continued his high level support in the revised edition that was in total very important. Harvey Goldfarb of All Risk Insurance was a huge help with the life insurance example and data, as was Alex Smith of Ashton Benefits with health insur- ance as well and Richard Rothberg of Cooley LLP was invaluable with the Estate Planning chapter. Finally, thanks for editorial assistance to Prateeksha Sabhani, Yisroel Zylberberg, and Matthew Suchow, all of whom made substantive improvements to the book. It is my hope that this book will contribute to the further development of personal finan- cial planning and enhance the stature of the discipline, the instructors who teach the course, the professionals who practice its fundamentals, as well as motivate students in its career possibilities.

Lewis J. Altfest

([email protected])


PART SIX Planning Essentials 505

16 Stocks, Bonds, and Mutual Funds 506

PART SEVEN Integrated Decision Making 535

17 Capital Needs Analysis 536

18 Behavioral Financial Planning 579

19 Completing the Process 612

PART EIGHT* Further Specialized Topics (Web Chapters) 1

A Educational Planning 2

B Background Topics 30

C Special Circumstances Planning 54

D Career Basics 82

E Regulation 96

APPENDIX* A Modern Investment Theory

B Employee Benefits

C Behavioral Finance—Applications

D Comprehensive Financial Plan—Dan and Laura




* Located online at www.mhhe.com/altfest2e

About the Author vi

Preface viii

PART ONE Planning Basics 1

1 Introduction to Personal Financial Planning 2

2 The Time Value of Money 25

3 Beginning the Planning Process 55

PART TWO Ongoing Household Planning 77

4 Household Finance 78

5 Financial Statements Analysis 109

6 Cash Flow Planning 130

7 Debt 151

PART THREE Portfolio Management 197

8 Household Investments 198

9 Real Estate and Other Assets 238

10 Financial Investments 264

11 Risk Management 310

PART FOUR Specialized Planning 353

12 Other Insurance 354

13 Retirement Planning 386

PART FIVE Tax and Estate Planning 425

14 Tax Planning 426

15 Estate Planning 464

Brief Contents


Basic Principles 26 Compounding 27 Using a Financial Calculator 28 Present Value 29 Future Value 31

Sensitivity to Key Variables 32 The Rule of 72 32 Compounding Periods 32 Discount Rate 33 Periods 34

Annuities 34 Future Value of an Annuity 34 Regular Annuity versus Annuity Due 34 Present Value of Annuity 35 Periodic Payment for an Annuity 36 Perpetual Annuity 36

Irregular Cash Flows 37 Inflation-Adjusted Earnings Rates 38 Internal Rate of Return 39 Annual Percentage Rate 39 Back to Dan and Laura 40 Summary 43 Key Terms 43 Website 43 Questions 43 Problems 44 Case Application 45 Appendix I Serial Payments 45 Appendix II Excel Examples 47

Chapter 3 Beginning the Planning Process 55

Chapter Goals 55 Real-Life Planning 55 Overview 56 Behavioral Finance 56

Cultural Background 57 The Life Cycle 57 Family 58 Personality 58

Some Principles of Communication 59 Listening 60 Showing Empathy 60 Establishing Trust 60

About the Author vi

Preface viii


Chapter 1 Introduction to Personal Financial Planning 2

Chapter Goals 2 Real-Life Planning 2 Overview 4 Why Is Financial Planning Important? 4 The History of Personal Financial Planning 4 Characteristics of Finance 5 Personal Finance 6 Personal Financial Planning 6 Personal Financial Planning Process 6 The Financial Plan 8

Parts of the Plan 9 Financial Planning as a Career 13

The Financial Planner 13 Types of Financial Advisors 13 What a Planner Does 13

Life Cycle Planning 15 Back to Dan and Laura 16 College Student Case Study and Review: Amy and John 18 Summary 20 Key Terms 21 Websites 21 Questions 21 CFP® Certification Examination Questions and Problems 22 Case Application 23 Appendix I Practice Standards 24

Chapter 2 The Time Value of Money 25

Chapter Goals 25 Real-Life Planning 25 Overview 26


xviii Contents

Interviewing 61 Preplanning 62 Beginning the Interview 62 Substance of the Interview 62 Conclusion 63

Financial Counseling 63 Goals 64

Approaches to Goals 65 Data Gathering 68 Back to Dan and Laura 70 College Student Case Study and Review: Amy and John 72 Summary 73 Key Terms 74 Questions 74 Case Application 75


Chapter 4 Household Finance 78

Chapter Goals 78 Real-Life Planning 78 Overview 79 The Household Structure 80 Theory: An Introduction 82 The Theory of Consumer Choice 82 The Life Cycle Theory of Savings 83 The Theory of the Firm 85 The Cost of Time 86 The Household Enterprise 86 The Transition to Finance 87 Household Finance 88 The Household as a Business 89 Modern Portfolio Theory 91 The Theory of Personal Financial Planning 91 Total Portfolio Management 92 Behavioral Financial Planning 93 Back to Dan and Laura 96 College Student Case Study and Review: Amy and John 97 Summary 100 Key Terms 101 Questions 101 Case Application 102 Appendix I Leisure Time 102 Appendix II Equilibrium Analysis: Labor and Leisure Hours 105

Appendix III The Life Cycle Theory of Savings 106 Appendix IV Divisions 108

Chapter 5 Financial Statements Analysis 109

Chapter Goals 109 Real-Life Planning 109 Overview 110 The Balance Sheet 110 The Cash Flow Statement 113 Operating Activities 114

Capital Expenditures 115 Financing Activities 115 Savings 115 Traditional Household Cash Flow Statement 116

Financial Statement Presentation 118 Balance Sheet 119 Cash Flow Statement 119

Pro Forma Statements 119 Pro Forma Cash Flow Statement 120 Pro Forma Balance Sheet 121

Finance versus Accounting 122 GAAP versus Household Accounting 122 Recording Transactions 123

Back to Dan and Laura 124 College Student Case Study and Review: Amy and John 125 Summary 127 Key Terms 127 Websites 127 Questions 128 CFP® Certification Examination Questions and Problems 128 Case Application 129 Appendix I Income Statement 129

Chapter 6 Cash Flow Planning 130

Chapter Goals 130 Real-Life Planning 130 Overview 131 Cash Flow Planning and Current Standard of Living 132

Reasons for Savings 132 Formal and Informal Budgeting 133

Purchasing Power 135 Emergency Fund 135 Liquidity Substitutes 136

Contents xix

Steps in Household Budget 137 Establish Budgeting Goals 137 Decide on the Budgeting Period 137 Calculate Cash Inflows 137 Project Cash Outflows 137 Compute Net Cash Flow 137 Compare Net Cash Flow with Goals and Adjust 138 Review Results for Reasonableness and Finalize the Budget 138 Compare Budgeted with Actual Figures 138

Financial Ratios 138 Liquidity Ratios 139 Operating Ratios 139

Life Cycle Planning 141 Back to Dan and Laura 142 College Student Case Study and Review: Amy and John 146 Summary 148 Key Terms 148 Website 148 Questions 148 Problems 148 CFP® Certification Examination Questions and Problems 149 Case Application 150

Chapter 7 Debt 151

Chapter Goals 151 Real-Life Planning 151 Overview 152 Risk and Leverage 153 Financial Leverage and Returns 154 Determining Simple Interest Rates 155

Payment of Interest at the End of the Period 155 Payment of Interest at the Beginning of the Period 156 Payment of Installment Loan 156 Annual Percentage Rate 157

Borrowing Factors 157 Sources of Debt 157 Interest Rates Charged by Lenders 157 Types of Borrowers 158 Credit Standards 158 Outcome 158 Long-Term versus Short-Term Debt 159 Secured versus Unsecured Debt 159

Mortgages 159 Loan Process 160 Prepayments on Mortgage Debt 162 Types of Mortgages 163

Refinancing 165 Home Equity Loans 166 Home Equity Line of Credit 167

Credit Card Debt 168 Margin Debt 169 Other Secured Debt 170 Bank Loans 170 Credit Union Loans 170 Pension Loans 170 Life Insurance Loans 171 Other Market Loans 171 Educational Loans 171 Loans from Relatives and Friends 171 Overall Procedure 171 Contingent Liabilities 172 Credit Reports 173 Financial Difficulties 175 Bankruptcy 175 Financial Ratios 178

Percentages Related to Debt 179 Debt-Related Ratios 179

Life Cycle Planning 180 Back to Dan and Laura 181 College Student Case Study and Review: Amy and John 183 Summary 185 Key Terms 186 Websites 186 Questions 187 Problems 188 CFP® Certification Examination Questions and Problems 189 Case Application 190 Appendix I Borrowing Theory: Risk and Equilibrium 190 Appendix II Consumer Protection Laws 191 Appendix III Privacy 193 Appendix IV Identity Theft 195


Chapter 8 Household Investments 198

Chapter Goals 198 Real-Life Planning 198 Overview 199 Defining and Detailing Nonfinancial Assets 199

xx Contents

Examining the Decision Process 201 Household Finance and Total Portfolio Management 201 Making Capital Expenditure Decisions 203 The Capital Expenditure Process 204 Capital Budgeting Techniques 205 Net Present Value (NPV) 205 Internal Rate of Return (IRR) 208 Comparison of IRR and NPV Methods 209

Analyzing Major Capital Expenditures 210 Durable Goods 210 Human Assets 212 The Home 214 Behavioral Realities 214

Evaluating the Leasing Alternative 215 An Introduction to Leasing 215 Reasons for Leasing 216 Automobile Leasing 216

Life Cycle Planning 218 Back to Dan and Laura 219 College Student Case Study and Review: Amy and John 221 Summary 222 Key Terms 223 Websites 223 Questions 223 Problems 224 CFP® Certification Examination Questions and Problems 225 Case Application 227 Appendix I Capital Budgeting Theory 227 Appendix II Assumed Rents 231 Appendix III Understanding the Lease Payment 231 Appendix IV Buy versus Lease—Car 233 Appendix V Excel Examples for NPV and IRR 235

Chapter 9 Real Estate and Other Assets 238

Chapter Goals 238 Real-Life Planning 238 Overview 239 The Home 239

Buy versus Lease—Home 243 Overall Appraisal of the Home as an Investment 244

Other Forms of Real Estate Ownership 246 Types of Real Estate 247

Advantages and Disadvantages of Business Real Estate Ownership 248 Real Estate Valuation Methods 249 Arriving at Cash Flow 249 Valuing Real Estate Cash Flow—The Cap Rate 250 Other Assets 252

Commodities 253 Gold 253

Life Cycle Planning 254 Back to Dan and Laura 255 College Student Case Study and Review: Amy and John 257 Summary 258 Key Terms 259 Websites 259 Questions 259 Problems 260 Case Application 261 Appendix I Buy versus Lease—Home 261

Chapter 10 Financial Investments 264

Chapter Goals 264 Real-Life Planning 264 Overview 265 Establish Goals 267 Consider Personal Factors 267

Time Horizon for Investments 267 Liquidity Needs 267 Current Available Resources 268 Projected Future Cash Flows 268 Taxes 268 Restrictions 268 Risk Tolerance 269

Include Capital Market Factors 270 Risk and Return 270

Identify and Review Investment Alternatives 273

Bonds 273 Common Stocks 273 Mutual Funds 274 Exchange Traded Funds 277

Evaluate Specific Investment Considerations 277 Active versus Passive Approach 277 Individual Securities versus Mutual Funds 278

Employ Portfolio Management Principles 279 Total Portfolio Management (TPM) 280

Formulate Asset Allocation Decisions 281 Establish an Active or Passive Management Style 281

Contents xxi

Construct a Strategic Asset Allocation 281 Develop a Tactical Asset Allocation 283

Select Individual Assets 283 Individual Fund Analysis 283

Finalize and Implement the Portfolio 287 Review and Update the Portfolio 289 Life Cycle Planning 290 Back to Dan and Laura 291 College Student Case Study and Review: Amy and John 294 Summary 298 Key Terms 299 Websites 299 Questions 300 Problems 301 CFP® Certification Examination Questions and Problems 301 Case Application 303 Appendix I Modern Portfolio Theory 303 Appendix II Measuring Performance 308 Appendix III Individual Fund Analysis 309

Chapter 11 Risk Management 310

Chapter Goals 310 Real-Life Planning 310 Overview 311 Real Management 311

Risk Management Theory 311 Risk Management in Practical Terms 312 The Risk Management Process 312

Insurance 317 What It Is 317 Insurance Theory and Practice 318 Types of Insurance Policies 319 Insurance Providers 319 Analyzing an Insurance Company 320 Insurance as an Asset 321

Summary of Risk Management and Insurance 322 Life Insurance 323

Life Insurance Goals 323 Parts of an Insurance Policy 324 Amount of Insurance 325 Types and Uses of Life Insurance 326 Term as Compared with Whole Life Policies 330

Life Cycle Planning 332

Back to Dan and Laura 333 College Student Case Study and Review: Amy and John 336 Summary 339 Key Terms 339 Websites 339 Questions 340 Problems 340 CFP® Certification Examination Questions and Problems 341 Case Application 343 Appendix I Quantitative Comparison of Policies 343 Appendix II Belth Method 350


Chapter 12 Other Insurance 354

Chapter Goals 354 Real-Life Planning 354 Overview 355 When Is Insurance Suitable? 355 Risk Management and Insurance Terms 356

Screening and Segregation of Applicants 358 Institution of Deductibles 358 Use of Coinsurance 358 Mutual Companies versus Stockholder-Owned Companies 359

Needs Analysis 359 General Characteristics 359 Tolerance for Risk 359 Personal Likelihood of Occurrence 359

Types of Insurance Coverage 360 Property and Liability Insurance 360

Property Insurance 360 Automobile Insurance 363 Liability Insurance 364 Umbrella Insurance 365

Personal Insurance 365 Health Insurance 365 Affordable Care Act 368 Disability Insurance 368 Long-Term Care Insurance 370

Government Insurance 372 Workers’ Compensation 372 Medicare 373

xxii Contents

Life Cycle Planning 374 Medicaid 375 Unemployment Insurance 375 Social Security Survivor’s Benefits 375

Back to Dan and Laura 375 College Student Case Study and Review: Amy and John 377 Summary 380 Key Terms 380 Websites 380 Questions 381 Problems 381 CFP® Certification Examination Questions and Problems 381 Case Application 384 Appendix I Monetary Windfalls 384

Chapter 13 Retirement Planning 386

Chapter Goals 386 Real-Life Planning 386 Overview 387 Familiarize Yourself with Retirement Issues 388 Develop Goals 389 Become Knowledgeable about Retirement Structures 390

Pensions 390 Social Security 394

Assess Types of Retirement Assets and Alternative Structures 398

Financial Assets 398 Human-Related Assets 399 The Home 400

Analyze Retirement Risks 401 Investment Risk 401 Inflation Risk 402 Longevity Risk 404 Health Risk 405

Decide on Retirement Investment Policy 406 Calculate Retirement Needs 406 Retired Households 407

Going for the Goals 407 Life Cycle Planning 408 Back to Dan and Laura 409 College Student Case Study and Review: Amy and John 411 Summary 414 Key Terms 414

Websites 414 Questions 415 Problems 416 CFP® Certification Examination Questions and Problems 416 Case Application 419 Appendix I Pension Plans 419 Appendix II Retirement Structure Summary 422


Chapter 14 Tax Planning 426

Chapter Goals 426 Real-Life Planning 426 Overview 427 Income Taxation 427 Income Tax Format 428 Tax Planning: A General Analysis 429

Marginal Analysis 429 Tax-Planning Strategies 432

Increasing Deductible Expenses and Credits 432 Tax Deferral 432 Conversion 433 Elimination of Taxes 435 Timing of Income and Expenses 437 Tax Planning for Investments 437

Tax-Advantaged Investments 440 Tax-Advantaged Investment Structures 440 Individual Tax-Advantaged Investments 441

Life Cycle Planning 443 Back to Dan and Laura 444 College Student Case Study and Review: Amy and John 446 Summary 448 Key Terms 448 Websites 448 Questions 449 Problems 449 CFP® Certification Examination Questions and Problems 450 Case Application 452 Appendix I Tax Theory 452 Appendix II Detailed Segments of an Income Tax Return 454

Contents xxiii

Chapter 15 Estate Planning 464

Chapter Goals 464 Real-Life Planning 464 Overview 465 Understand What Estate Planning Is 466 Identify Objectives 466 Identify Assets 467 Establish a Will 467

General Evaluation 467 Intestate 468 Selected Reasons for Having a Will 468

Consider Other Estate Planning Tools to Meet Objectives 469

Trusts 469 Gifts 472 Titling and Transferring of Assets 474 Life Insurance 475 Power of Attorney 476 Letter of Instruction 476

Evaluate Obstacles and Ways to Overcome Them 477

Probate 477 Conflict 477

Become Familiar with All Types of Relevant Taxes 479

Estate Taxes 479 Gift Taxes 479 Income Tax 479

Determine Available Financial Planning Strategies 480

Use Portability 480 Consider a Bypass Trust 480 Follow an Investment Policy for Estate Planning 482 Consider Placing Monies in Joint Name in Smaller Estates 482 Integrate Estate and Income Tax Considerations in Planning 483 Gift Fast-Growing Assets 483 Pay Compensation to Executor on Large Estates 483 Think about Designating Younger People as Heirs 483 Give Consideration to the Step-Up in Basis 483 Pay Particular Attention to IRAs and Other Qualified Plans 483

Incorporate Estate Risks 484 Longevity 484 Incapacity 484

Consider Separately Estate Planning for Minors 485

Assess Anticipated Resources 486 Finalize the Estate Plan 486 Implement the Plan 487 Review Periodically 487 Life Cycle Planning 488 Back to Dan and Laura 489 College Student Case Study and Review: Amy and John 490 Summary 492 Key Terms 493 Websites 493 Questions 494 Problems 495 CFP® Certification Examination Questions and Problems 495 Case Application 499 Appendix I Altruism and Bequest Theory 499 Appendix II Power of Appointment and QTIP Trusts 502 Appendix III Summary of Characteristics of Types of Trusts 503


Chapter 16 Stocks, Bonds, and Mutual Funds 506

Chapter Goals 506 Real-Life Planning 506 Overview 507 Bonds 507

Liquidity Risk 509 Bond Characteristics 510 Calculating the Value of a Bond 512 Types of Fixed Obligations 513

Preferred Stocks 515 Stocks 516

Fundamental Analysis 516 Technical Analysis 516 Valuation Methods 517

Mutual Funds 520 Bond Funds 520 Open-End versus Closed-End Funds 521 Load versus No-Load Funds 522 Mutual Fund Performance 523 Taxation 524

Other Investment Management Structures 524 Separately Managed Accounts 525 Exchange-Traded Funds 525

xxiv Contents

Unit Investment Trusts 526 Variable Annuities 526 Pension Plans 526

Back to Dan and Laura 526 Summary 528 Key Terms 528 Websites 529 Questions 530 Problems 531 CFP® Certification Examination Questions and Problems 531


Chapter 17 Capital Needs Analysis 536

Chapter Goals 536 Real-Life Planning 536 Overview 537 Simple Capital Needs Analysis 538 Capital Needs Analysis—Risk-Adjusted 538 Total Portfolio Management 540

Use of All Assets 541 Use of Correlations 542 Integration of Investments and PFP 543

Simple Capital Needs Analysis Withdrawal Rate Method 544

Establish the Assumptions and Facts 545 Calculate the Amount of Financial Assets at Retirement 545 Determine the Annual Cost of Living Beginning in Retirement 546 Ascertain the Amount of Annual Income Available for Retirement 546 Develop the Initial Annual Withdrawal Amount Needed 546 Compute the Annual Withdrawal Rate 546 If Necessary Review and Reconsider Key Figures 546 Finalize the Savings and Withdrawal Pattern 547 Review and Update 547

Simple Retirement Needs Analysis Regular Form 549

Review Goals 550 Establish Risks and Tolerance for Them 550 Determine Rates and Ages to Be Used for Calculations 550 Develop Retirement Income, Expenses, and Required Capital Withdrawals 550 Calculate Lump Sum Needed at Retirement 552

Identify Current Assets Available at Retirement 552 Compute Yearly Savings Needed 552 Project Income, Expenses, and Savings during Remaining Working Years 552 Reconcile Needs and Resources 552 Finalize Plan and Implement 552 Review and Update 553

Projections 553 Retirement Needs Case Study 554

Review Goals 554 Establish Risks and Tolerance for Them 554 Determine Rates and Ages to Be Used for Calculations 554 Develop Retirement Income, Expenses, and Required Capital Withdrawals 554 Calculate Lump Sum Needed at Retirement 554 Identify Current Assets Available at Retirement 555 Compute Yearly Savings Needed 555 Project Income, Expenses, and Savings during Remaining Working Years 555 Reconcile Needs and Resources 555 Finalize Plan and Implement 556 Review and Update 556

Back to Dan and Laura 559 College Student Case Study and Review: Amy and John 567 Summary 570 Key Terms 570 Website 570 Questions 570 Problems 571 CFP® Certification Examination Questions and Problems 572 Appendix I Life Insurance Needs Analysis and Case Study 573 Appendix II A Shorter Method for Calculating Retirement Needs 578

Chapter 18 Behavioral Financial Planning 579

Chapter Goals 579 Real-Life Planning 579 Overview 580 Determine the Goal 581 Establish the Role of Behavioral Finance 582 Understand What Behavioral Financial Planning Is 582 Separate Human Shortcomings into Categories 583

Contents xxv

Provide Selected Behavioral Models and Characteristics 584

Heuristics and Biases 584 Loss Aversion 585 Behavioral Life Cycle Theory 585

Learn about Ways of Overcoming Behavioral Shortcomings 586

Restricting Negative Behavioral Responses—Overall 586 Savings Mechanisms and Control 587

Apply Behavioral Characteristics to PFP 588 Summarize “Money Planning” 588 Broaden Behavioral Financial Planning to Include Life Planning 591 Become Familiar with the Financial Planners’ Function in Behavioral Analysis 594 Evaluate the Benefits of Behavioral Financial Planning 595 Life Cycle Planning 597 Back to Dan and Laura 598 College Student Case Study and Review: Amy and John 600 Summary 602 Key Terms 602 Websites 602 Questions 603 Case Application 604 Appendix I Behavioral versus Rational Finance 604 Appendix II Categories of Human Behavior 606 Appendix III Additional Behavioral Models and Characteristics 606 Appendix IV Noneconomic Behavior 610

Chapter 19 Completing the Process 612

Chapter Goals 612 Real-Life Planning 612 Overview 613 PFP Theory 614 The Financial Plan 616

Establish the Scope of the Activity 617 Gather the Data and Identify Goals 617 Compile and Analyze the Data 617 Develop Solutions and Complete the Plan 623

Delivery of Plan 624 Monitoring the Financial Plan 627

Life Cycle Planning 628 Back to Dan and Laura 629 College Student Case Study and Review: Amy and John 640 Summary 641 Key Terms 642 Website 642 Questions 642 Problem 642 CFP® Certification Examination Questions and Problems 643 Case Application 644 Appendix I Household and Business Characteristics 644 Appendix II Review Statements 645 Appendix III The Money Ladder 647


Web Chapter A Educational Planning 2

Chapter Goals 2 Real-Life Planning 2 Overview 3 Educational Policy Statement 4

Establish Educational Goal 4 Calculate the Cost of Education 5 Project the Potential for Financial Aid 5 Estimate the Total Cost for Parents 6 Determine Best Savings Structures 7 Establish Investment Policy 10 Estimate the Amount of Annual Funding Needed 10

Planning for Financial Literacy 11 Back to Dan and Laura 15 College Student Case Study and Review: Amy and John 17 Summary 18 Key Terms 19 Websites 19 Questions 20 Problems 21 CFP® Certification Examination Questions and Problems 21 Case Application 23

xxvi Contents

Appendix I Educational Needs Calculation 23 Appendix II Career Planning—Job Change and Job Loss 25

Web Chapter B Background Topics 30

Chapter Goals 30 Overview 30 Macroeconomic Topics 30

Demand and Supply Analysis 30 Inflation 31 The Business Cycle 34 Economic Indicators 36 Fiscal Policy 38 Monetary Policy 38 Yield Curves 40

Financial Institutions 41 Commercial Banks 41 Savings Banks and Savings and Loans 42 Credit Unions 42 Insurance Companies 42 Brokerage Firms 43 Mutual Funds 43 Other Financial Institutions 44

Types of Business Entities 45 Individual Proprietorships 45 Partnerships 45 Corporations 46

Business Law 47 The Contract 47 Torts 48 Negligence 48 Negotiable Instruments 48 Liability 48 Arbitration and Mediation 49

Summary 49 Key Terms 50 Websites 50 Questions 51 CFP® Certification Examination Questions and Problems 51

Web Chapter C Special Circumstances Planning 54

Chapter Goals 54 Real-Life Planning 54 Overview 55

Relationship Planning 56 Divorce Planning 56 Remarriage 60 Nontraditional Families 61 Domestic Partnership Agreement and Other Legal Arrangements 64

Wealth Planning 65 Asset-Wealthy People 65 Business Owners 66 Corporate Managers 68

Health and Aging 69 Disability and Special Needs Planning 70 Elder Care Planning 72 Terminal Illness Planning 74

Back to Dan and Laura 76 Summary 78 Key Terms 78 Websites 78 Questions 79 Problems 79 CFP® Certification Examination Questions and Problems 80 Case Application 81

Web Chapter D Career Basics 82

Chapter Goals 82 Real-Life Planning 82 Overview 82 The Business Plan 83

Obtain Proper Education and Experience 83 Secure the Services of Other Advisors 84 Develop a Mission Statement 84 Establish the Services and Structure of the Firm 84

Decide on a Form of Compensation 85 Select a Broker-Dealer 87 Develop Policy Statements 87 Select Technology for Operations 88 Recognize the Link between Communications and Operations 88 Construct a Marketing Plan 89 Prepare an Engagement Letter 90 Develop Risk Management Procedures 91 Develop an Objective Plan for Monies Needed 91

Career Profiles 92 Summary 94 Key Terms 95 Websites 95 Questions 95

Contents xxvii

Web Chapter E Regulation 96

Chapter Goals 96 Real-Life Planning 96 Overview 96 General Standards of Proper Professional Behavior 97

Competency 97 Suitability 97 Reporting 98 Due Diligence 98 Compliance 98 Documentation 98 Ethical Behavior 98

Regulation of Investment Advisors 99 Terms of the Investment Advisers Act 99 Obligations of an Investment Advisor 100

Other Financial Services Regulatory Activity 102 The FINRA 102 Broker-Dealer Regulation 103 Compliance 103 Insurance Regulation 103 Other Professionals 104

Targeted Areas 104 CFP Code of Ethics and Practice Standards 105

Principles 105 Rules 105 Practice Standards 108

Summary 109 Key Terms 110 Websites 110 Questions 111 Problems 111 CFP® Certification Examination Questions and Problems 112 Appendix I Arbitration 114

Web Appendix A Modern Investment Theory Web Appendix B Employee Benefits Web Appendix C Behavioral Finance—Applications Web Appendix D Comprehensive Financial Plan— Dan and Laura

Glossary 648

Suggested Readings 661

Index 666

Part One

The Theory of International Trade 1. Introduction to Personal Financial Planning 2. The Time Value of Money 3. Beginning the Planning Process

For centuries people have been fighting over whether governments should allow trade between countries. There have been, and probably always will be, two sides to the argument. Some argue that just letting everybody trade freely is best for both the country and the world. Others argue that trade with other countries makes it harder for some people to make a good living. Both sides are at least partly right. For centuries people have been fighting over whether governments should allow trade between countries. There have been, and probably always will be, two sides to the argument. Some argue that just letting everybody trade freely is best for both the country and the world. Others argue that trade with other countries makes it harder for some people to make a good living. Both sides are at least partly right.

Part One

Planning Basics 1. Introduction to Personal Financial Planning 2. The Time Value of Money 3. Beginning the Planning Process

In this part, Planning Basics, you will learn the preliminaries necessary to perform personal financial planning. Chapter 1 is an overview of the entire PFP process and details the segments of a financial plan. It also introduces a case study that we will develop throughout the book. Unlike many other case studies you may have come across, this one provides the solutions using the facts developed by a financial plan- ning practitioner. Chapter 2 examines the time value of money, one of the basic ideas in finance. It provides virtually all the mathematical techniques you will need to perform the cal- culations required throughout the book. Chapter 3 begins the planning process with what can be called its initial stages. These include goal setting, data gathering, and understanding how to communicate with others. With an understanding of these topics, these topics under your belt, you will be prepared for the financial planning activities that lie ahead.


Chapter Goals

This chapter will enable you to:

• Understand what personal financial planning (PFP) is and how it works.

• Place goals at the head of the PFP process.

• Become familiar with PFP’s financial and personal frameworks.

• Understand the specific role of financial planning and the financial plan as a com- prehensive integrated process.

Dan and Laura, both age 35, were recently married. Each works, Dan as a systems engi- neer and Laura as a teacher. They want to make major decisions concerning their lives, and they have questions about the cost and the timing of having children, purchasing a house, and maintaining a “great” lifestyle. They have heard that personal financial planning might be helpful. Dan and Laura know little about finance and nothing about planning, so they made an appointment with a financial planner to find out about it. Their questions are basic: What is personal financial planning? How can it help us achieve our goals? Can we do financial planning ourselves? Their immediate concern is the debt they are accumulating. (To be continued at chapter’s end.)

Real-Life Planning

Maria stepped into the advisor’s office looking awkward. She appeared to be unsure that she belonged there. Maria wasn’t the advisor’s typical client. She was a young messenger for a national package delivery firm who had occasionally delivered items to the advisor’s previous office location. She arrived in her uniform without an appointment. Her face showed that she was troubled by something and needed an answer right then. The advisor ushered her into his office, offered her a soft drink, and discussed some things they had in common. When she seemed more at ease, he asked why she had come. She said her husband was thinking of purchasing a second house and renting it out. She, on the other hand, was against doing this. It would require almost all of their nonretirement savings for just the down payment and they would have to take on significant additional mortgage debt. She said she could not stop thinking that if this investment soured, it could ruin their savings, expose their existing investment in their home to risk, and, most

Chapter One

Introduction to Personal Financial Planning

Chapter One Introduction to Personal Financial Planning 3

importantly, jeopardize their plans to raise a family. Maria said that the dispute was seri- ously affecting their relationship and she and her husband fought constantly over this out- lay. She asked the advisor what he thought of the investment for them. The advisor did some data gathering. He found that both husband and wife had full-time jobs that provided moderate sources of income. They seemed to have sound financial oper- ations that generated significant savings each year, and they had accumulated a decent sum. Both liked their work and had opportunities to advance and raise their income. They planned on working until full retirement in their existing jobs even if the government pushed back the retirement age for full Social Security. They had no debt outstanding except for their mortgage. Their employer covered their health insurance and other benefits, and they had purchased additional life insurance on their own. Like many young people, they hadn’t gotten around to making a will. Their goals were not complex. They wanted to start a family within a few years and to continue what was from the advisor’s perspective a relatively modest but comfortable life- style. Maria said they didn’t want to worry about their financial future. The advisor then focused on the real estate investment. He asked her the purchase cost of what turned out to be another house in their neighborhood. A quick calculation indi- cated they could make a significant annual sum by renting it out after expenses, including interest on debt borrowed and maintenance costs. The advisor asked whether she was con- fident of the figures, and she said that she knew both projected rental income and costs. Her husband was handy and would supervise the project. The advisor asked about the outlook for the neighborhood and was told it was one for people with modest incomes but was becoming popular with younger, more affluent urban dwellers. The advisor then thought about what he wanted to say to Maria. Often his recommenda- tions incorporated two factors, a blend of what was financially best and, whenever feasible, what the client’s preferred alternative was. In this case, he believed there was no conflict between the two approaches. The husband was not an irrational risk taker. Purchase of the house made financial sense. What remained were Maria’s concerns. The advisor decided to find out whether Maria had a low tolerance for risk or just needed some advice and support in an area she feared. Despite not having enough notice to analyze the situation in greater depth, he told her that while any investment contained risk, this investment seemed sound. If her figures and appraisal were correct, her husband should be commended for his enterprising thoughts. The investment income from the property could replenish their sav- ings fairly quickly. Moreover, it could bring them closer to realizing their financial goals. The smile that broke out on her face and her more relaxed manner told the advisor that all she needed was some confidence in the idea. He gave her the names of some mutual funds to invest in when their cash was re-established and advised her to make an appointment with a lawyer to draw up a will within two weeks. He told her to review the real estate investment and her savings each year after it was bought. The advisor declined any money for this “engagement.” He said the satisfaction he got from being helpful was pay enough. As he accompanied her out, the advisor realized that he had performed the major steps in the financial planning process. Both he and Maria had established that the planning scope was to discuss the real estate investment. However, in order to make proper recommenda- tions, he had to gather data, establish goals, and analyze a broad range of information. In fact, in the space of a very short time he had composed a kind of financial checkup with selected elements of a mini-financial plan for someone with a fairly simple financial life. He had concluded that the couple was on the right financial path. He made some rec- ommendations and included some implementation steps that extended the original scope. The whole process was completed over a moderately longer than normal lunch period, just in time for his next scheduled client.

4 Part One Planning Basics


Personal financial planning (PFP) is a practical activity whose objective is to help achieve your goals. This chapter provides an introduction to it and begins with a look at the overall planning setting including why PFP is important, its history, and its placement within the finance field. The chapter moves on to the heart of planning, describing the fixed process that is used to increase the chance for reaching the objective. The planning process is what defines the profession of personal financial planning. The financial plan itself is discussed with an emphasis on its comprehensive integrated approach. Finally, the chapter discusses financial planning as a career and the practice standards to which planners must adhere. Thereafter, the Dan and Laura financial plan is introduced, which will serve as a unified case study for each chapter in the book. You should find it useful in helping you under- stand how actual planning is performed. Knowing how financial planning operates as described in this chapter will serve as a useful backdrop for the information and techniques to be introduced throughout the book. More importantly, knowledge of this information and utilization of the PFP process should result in better decision making and improvement in outcomes. In other words, it can pro- vide material help in achieving the goals you set out.


Financial planning is important because we live in a fast-paced world in which an ever- increasing number of financial alternatives are presented to us. At the same time, informa- tion through all kinds of media, including the Internet, is available to help us make selections. Making wise decisions enables us to achieve our goals. Financial planning, which includes gaining insight into the efficient way to perform a task and then handling it in a logical, disciplined way, enables us to further our objectives. Personal financial planning has become even more important in the twenty-first century because of the extraordinary events that have already transpired. For many people, owning a home has been and continues to be a keystone of their personal finances. Home prices soared at an unprecedented rate in the early years of this century, yet lenders made it all too easy to buy high-priced homes by offering easy credit. When the housing bubble burst, many home- owners learned a new expression—under water—meaning that they owed more than their home was worth. Knowledge of sound savings and borrowing strategies could have helped. In addition, retirement planning is an increasingly important area of personal finance, yet stock market shocks have temporarily, and in some cases permanently, affected retire- ment portfolios including two major declines in 2000 and 2008. In order to confidently prepare for retirement, workers must develop prudent investment strategies that are another component of personal financial planning. Understanding personal financial planning and being comfortable with our own plan- ning efforts have important benefits for society as well. They allow us to dedicate our full efforts to the job at hand at work. They also may make us more effective at that job because the household and the business approach many problems in the same way, and many per- sonal financial planning techniques are useful in work-related situations.


Personal financial planning (PFP) has existed for many years. Until well into the twentieth century, however, it was generally restricted to very wealthy people who were advised by

Chapter One Introduction to Personal Financial Planning 5

their lawyers, accountants, registered representatives, insurance agents, investment advi- sors, or bankers. Around 1970, these services began expanding to a larger population. Many middle- class people had the discretionary income and desire to seek help with the growing com- plexity of financial instruments and services. The new personal financial planners developed as professionals who could provide solutions to a range of financial problems and coordinate the activities of their clients’ other advisors. Established in 1972, Money magazine and later a wide variety of additional publications and other media helped inform the broad population in financial planning matters and in the usefulness of consulting financial planners.


In this and the following two sections, we will place PFP within an overall setting in the finance field. Finance deals with the management of funds, among other money issues. Individual businesses and government all have concerns over use of funds. We can say that finance is a practical field of study that is based principally on cash flow. Cash flow is the amount of money made available for use. Finance is concerned with such variables as

1. Markets. Places where tangible goods and financial instruments such as stocks and bonds are bought and sold.

2. Capital. The real, financial, and human-related assets that are generated by individuals and organizations or bought and sold in the marketplace.

3. Market structures. The economic operations of the business, the government, and the household that facilitate the purchase and sale of items.

4. Market value. The market-established worth of a product or a financial instrument. 5. Fair value. The inherent worth of nonmarketable assets based on cash flow, risk, and

the time value of money principles.

6. Cash flow. The economic operation of the organization based on the cash it generates. 7. Risk. The uncertainty of outcomes. 8. Investments. Placing cash flow into assets designed to improve an organization or to

provide future funds for consumption.

In an academic program, finance is generally broken down into courses on personal finance and business finance, with second-level courses such as investments analysis and portfolio management, capital markets, and capital budgeting. We will discuss all items above as they pertain to personal finance and personal financial planning. Let’s begin with personal finance.

This book is intended to go beyond an introduction to personal finance facts to provide you with the tools to analyze and plan for your own financial future. It is written by a college professor who is also a professional financial advisor with hundreds of cli- ents and more than $1 billion in assets under man- agement. Visualizing yourself as a financial planner

can be useful even if you are also the only client. This should help you better understand finance in- cluding business finance. It can provide you with knowledge that will serve you throughout your life whether you remain the planner’s sole client or be- come a part- or full-time professional.

Professional Advice Use of This Book

6 Part One Planning Basics


Personal finance can be defined as the study of how people develop the cash flows neces- sary to support their operations and provide for their well-being. Household finance, the subject of Chapter 4, is the study of how a household and the people in it develop the cash flows necessary to support operations and provide for the well-being of its members. Basic finance tools such as the time value of money, cash flow analysis, investment models of behavior, and risk analysis form the backbone of personal finance and PFP. These tools are discussed in this and subsequent chapters. As you will see, a wide variety of other disciplines have a significant role in the practice of personal finance and PFP. Some of these are listed next.


Personal financial planning can be thought of as the analysis and decision-making exten- sion of personal finance. Basically, PFP must satisfy four broad categories of personal- finance decisions: consumption and savings, investments, financing, and risk management.


Personal financial planning can be defined as the method by which people anticipate and plot their future actions to reach their goals. When we engage in financial planning, it is usually to solve a problem or to structure a plan for the future. In either case, we go through the following steps of the decision-making process:

1. Establish the Scope of the Activity Establishing the scope answers the question: How broad an area are we analyzing? For financial planning practitioners, the scope defines the specific services that they will

Discipline Explanation

Microeconomics The study of single units in the economy. It helps us understand how people and households allocate scarce resources.

Macroeconomics A broad study of the functioning of the entire economy or a major section of it. Economic conditions often have a strong influence on household actions.

Accounting1 System of recording and analyzing financial transactions. It helps organize and analyze financial data in a logical way.

Law The entire body of rules, practice and customs. They serve as a benchmark of correct rules and regulations for PFP.

Taxation The imposition of taxes to obtain revenues. Taxes are a key factor in decision making for virtually all parts of PFP.

Mathematics The science of numbers and their operations. Mathematics helps develop logical thinking and forms the quantitative basis for efficient decision making.

Statistics A means of collecting relevant data. The examination of accumulated statistics helps establish or verify proposed PFP actions.

Business A purposeful commercial activity. As will be established in Chapter 4, household operations resemble a business in many respects.

Psychology The study of mind and behavior. Psychology can provide one input into appropriate human actions.

Sociology The analysis of the behavior of groups of humans. Along with psychology it helps in understanding how people act as distinct from how they should act.

1 Modified from Webster’s Ninth New Collegiate Dictionary (Springfield, MA: Merriam-Webster Inc, 1988).

Chapter One Introduction to Personal Financial Planning 7

provide.2 For example, are they concentrating on saving money for a down payment on a home, or are they examining the entire financial planning process?

2. Gather the Data and Identify Goals In order to solve the problem as financial planning practitioners, we must gather certain information. We accumulate data on household financial assets and information on income and expenditures. In addition, we develop information on limiting factors such as health, time available, and tolerance for risk. A person or household can have many types of goals at any point in time. Goals that arise from values differ by household. The underlying goal, however, is to have the highest standard of living possible. The time devoted to work and types of leisure activities and expenditures will vary with each individual.

3. Compile and Analyze the Data We funnel the data received into the balance sheet, the statement of assets and liabilities, the cash flow statement, which provides the household cash revenues and expenses/outlays, and any other statements that are relevant. After that is done, we proceed to analyze the statements and establish the client’s overall financial position. What are the resources that are available? For example, does the balance sheet suggest a safe level of borrowing or does the house- hold have a high level of debt? If there is a great deal of debt, does the cash flow indicate that paying it off may be a problem in the future? All major parts of financial planning are considered and any special needs included.

2 When a financial planner is involved, according to the Practice Standards established by the CFP Board, this scope would include the range of services to be provided, how the planner is compensated, how long services will be provided, and so forth. Instead of terming this first step “Establish the Scope of the Activity,” the CFP Board calls it “Establishing and Defining the Client-Planner Relationship.”

Reason Principal Category

1. Inability to save properly. Consuming and saving 2. Need to resolve a debt problem. Financing 3. Desire to retire comfortably on time. Consuming and saving* 4. Desire to improve investment returns. Investing 5. Discomfort with present risk profile. Managing risk 6. Beset by economic turmoil Setting new goals and objectives

* Incorporates other areas as well.

Most people focus on financial planning for them- selves because they have a particular problem or goal in mind. As financial planners are aware, few clients come in asking for a review of their finances or a financial plan. Just as most patients, particu- larly younger ones, come to a doctor with a

symptom rather than for a check-up, we can say that most clients come to a planner with a “finan- cial hurt.” Some of the most common reasons for the visit and the broad categories of financial planning they fall into are

Practical Comment Why People Seek Financial Planners

The financial hurt and the category it falls into give rise to a financial planning process for solving it. Often other financial categories are drawn into the process. The result is that, the single financial hurt

frequently results in a more comprehensive look at the person or household. The financial planning pro- cess and the financial plan that often provides the solution for the “hurt” is presented here.

8 Part One Planning Basics

4. Develop Solutions and Present the Plan There are often many different ways to solve a problem. There are hosts of products that are available and many alternative services or practices to call on. For example, if the client’s goal is to save more money, this can be done simply by placing more money in a savings account, purchasing a whole life insurance policy instead of a term one, or buying a bigger house with a larger mortgage whose payment of principal each month could be considered a form of saving. The best solution is usually the one that solves the problem at the lowest cost. In the case of the savings problem mentioned, the lowest-cost solution, assuming it is followed, would probably be simply to make regular deposits into a savings account.

5. Implement Implementation is the action step. It is taking the best solution and putting it into practice. Although this may sound simple, for many people it is difficult to accomplish. This may be due to simple inertia or the action steps may be painful to carry out (saving money, for example).

6. Monitor and Review Periodically All planning procedures are subject to change. Incomes change, life situations change—some people get married, some of them get divorced, and many have children. In addition, individ- ual goals may need to be altered as a person ages. The environment we live in changes as well. Therefore, all planning procedures must be monitored for material changes and reviewed peri- odically to ensure they remain up to date. This process is summarized in Figure 1.1.


The financial plan is a structure through which you can establish and integrate all your goals and needs. It, therefore, can be the practical embodiment of the financial planning pro- cess and the tool to assist in implementing the process. The financial plan may take the form of a detailed written document—particularly if you consult a financial practitioner. It is then

Establish scope of activity

Gather data and identify goals

Compile and analyze data

Develop solutions and present plan


Monitor and review

FIGURE 1.1 Personal Financial Planning Process

Chapter One Introduction to Personal Financial Planning 9

often referred to as a comprehensive financial plan. Alternatively, it could be summa- rized on a single sheet of paper, even written on the back of an envelope, or could exist just in the head of the person in charge of the household’s financial affairs. The key decision is a commitment to the financial planning process, including its analytical component. In other words, the financial plan is an organizational tool that can aid in financial planning.

Parts of the Plan The plan can be separated into 11 parts, each of which is explained briefly next.

1. Establishing goals. Establishing goals involves deciding on your priorities not only for living not only today but also for the rest of your life. It is the reason the plan is made. Therefore, all the other parts of the plan follow this one. We describe goals more fully in Chapter 3.

2. Analyzing financial statements. Financial statements provide a current picture of your financial condition. They present the resources that are available to fund your goals. Financial statements include a balance sheet, a cash flow statement, and other relevant statements.

3. Cash flow planning. In cash flow planning, household income and expenditures and other cash flows are compiled and analyzed. The goal is to plan income and expense flows so that work, cost of living, savings and investment, and financing issues inter- act in an optimal way to provide the highest returns possible.

4. Tax planning. Tax planning is the practice of attempting to minimize unnecessary tax payments to the government. It is done by applying allowable tax deductions, credits, and other forms of tax benefits.

5. Investment planning. Through investments, you enable your net cash flows to grow as rapidly as possible, subject to your tolerance for risk. Generally households have a portfolio of human, real (ones you can touch), and financial assets to consider in the investment process.

6. Risk management. The objective of risk management is to control the level of risk and consequently of loss for each significant household asset and for the entire portfo- lio of assets. It involves implementing certain risk-modifying practices and consider- ing products such as insurance.

In common usage, the public sometimes views a fi- nancial plan as a written document to identify their needs and the solution to them, not as a rigorously defined document. As we have noted, most people come to a financial planner for a solution to one or two problems, not for a comprehensive solution. Consequently, people may consider, for example, an investment review or a retirement plan as a financial plan. A financial plan has a defined minimum scope, which is detailed in this section. As discussed, when prepared by a financial planner, the document is often referred to as a comprehensive financial plan. The use and form of this document will vary con- siderably among financial planners. Some use it to

form the basis of an ongoing relationship. Others employ it at the end of an extended process of look- ing at client activities. Some make it a highly detailed document; others summarize it in a few pages. Unless any planning document is geared to a specific client and deals with all relevant factors of the client’s financial life, it will not be as useful as it could be. Said differently, whether engaging in f inancial planning orally, in summary form, in a seg- mented plan—one that focuses on just one or a few areas—or in a comprehensive financial plan, the key is to incorporate all the relevant client factors and gear recommendations to the individual needs of the client.

Practical Comment Elements of a Financial Plan

10 Part One Planning Basics

7. Retirement planning. Retirement planning focuses on household saving and invest- ing decisions that allow you to retire at the age and lifestyle that you desire. Ideally, the process for this goal, which for many people has a high priority, starts early in the establishment of the household.

8. Estate planning. Estate planning generally deals with planning for yourself and others while you are alive and for current and former members of your household and other people or institutions upon your death. It usually involves a combination of legal, tax, and personal wishes for other members of the household. In addition, it involves planning for future household members such as children, particularly when the monetary goal for ac- cumulation of assets at the time the last member of the household dies is more than zero.

9. Special circumstances planning. Special circumstances planning is a miscellaneous category for handling other goals and activities. Examples include planning for elderly parents, special needs for children, marital or divorce considerations, or business be- cause each pertains to personal financial planning.

10. Employee benefit planning. Employee benefits are the forms of compensation other than salary. The objective regarding them is to understand and integrate the best mix of employer and independently funded products, services, and other planning mechanisms. When applicable, employee benefits can be provided as a separate section but are often listed under the other relevant sections of the plan, an approach that we will follow.

11. Educational planning. Educational planning is preparing financially for the outlays for educating adult and children members of the household. Most commonly, expenditures are for college and graduate school. The objective is to have sufficient monies prior to the expenditure utilizing all appropriate tax-advantaged mechanisms.

The parts of a financial plan are presented in Figure 1.2. Note that goals are placed at the top because they are the reason for the plan. Analysis of financial statements follows as a prerequi- site of the active financial planning segments. Integration is presented toward the bottom of the figure because it serves to ensure that the goals in each section can be accomplished. The following is a practical example of the entire financial planning process and of the parts of a simple financial plan.

Example 1.1 The following situation demonstrates one fairly common financial issue and the process and outcome for dealing with it. Elliot and Marsha went to a financial planner with a specific goal: to save money for the down payment on a home. They had wanted their own home for some time but always seemed to spend all their money each week. The planner went through the

Financial planning is more than the sum total of in- dividual goals for each section. Household resources are limited. Integration considers goals and re- sources as a whole and at how actions in one part of the plan can affect other areas. For example, money saved in a pension plan can increase investment sums, reduce retirement planning and estate plan- ning needs, and, of course, result in fewer resources available for spending today. Integration presents a reality check on what can or cannot be achieved, which, in turn, can result in a

modification of certain financial planning goals. It is an action that should be taken before each decision has been made. A comprehensive plan incorporates integration in that its parts are coordinated. Sometimes the word holistic is used to refer to the integrative approach. Although it isn’t a section in the financial plan, integration can be thought of as the final step, and it will be the subject of the final section of the book.

Practical Comment Integration

Chapter One Introduction to Personal Financial Planning 11

six-step financial planning process to assist them with their needs. First, he established that planning would be limited principally to their down payment goal but that he would make other comments that might be helpful to them. The financial planner then began the data-gathering process. He learned that Elliot and Marsha were recently married; both worked and spent all of their available monies on what they described as enjoying themselves. They had little in the way of assets other than their income-earning ability. Their overall goals were clearly to continue to enjoy life today and to acquire a home. The advisor mentally went through all the parts of a financial plan in connection with his analysis of the data. When appropriate, he asked the couple questions. Elliot and Marsha had a significant combined income and modest liabilities. The planner decided that cash flow plan- ning would be the key to the work in that session. He compiled their incomes and nondiscre- tionary living expenses. The remaining money would be sufficient for the couple to accumulate enough for a down payment to purchase a home in two years yet enable them to continue most of the activities they enjoyed today. There didn’t seem to be any material tax planning issues other than the tax benefits available through home ownership. A preliminary discussion indicated no employee benefits topics that seemed appropriate for this project. Investment analysis would be involved in two ways. The first was to decide where the projected savings would be placed. The second was to incorporate investment information in deciding on the specific home to be purchased. The couple were fairly careful in their per- sonal activities. They had a moderate tolerance for risk, had insurance (including term insur- ance at work), and didn’t want to consider additional sums or types at the present time. Both Elliot and Marsha had a 401(k) pension plan at work but weren’t contributing to it. Retirement planning was a low priority for them at this time. Estate planning was even more remote and neither had a will. There were no specialized planning issues. The advisor decided that a simple two-page written document would be sufficient for them given their goals, situation, and the resources they wanted to allocate to the planning process. The document would embody the solutions to their needs in the form of a list of recommenda- tions. He repeated the goals and scope of the project. They included

1. A recommended savings amount per person per paycheck. Contributions to their 401(k) pen- sion plans at work would come directly out of their paychecks, thus ensuring compliance. A cash flow statement demonstrated that the purchase of a home was possible in two years.

2. An investment approach that was highly conservative. Savings were to be placed in money market funds or bank certificates of deposit (CDs) based on how soon the accumulated sums were to be used. Even though the yields would be relatively low, risk of loss would be scant.

3. A recommendation that the couple begin retirement savings as soon as their home was purchased. If possible, each would contribute the maximum amount to a 401(k) account.

4. A recommendation that each establish a will as soon as possible. The advisor offered to give them the name of some qualified attorneys.

Financial plan for achieving goals

Financial integration

Establishment of goals

Estate planning

Special circumstances


Retirement planning

Risk management

Tax planning

Cash flow planning

Investment planning

Analysis of financial statements

Employee benefit


Educational planning

FIGURE 1.2 Parts of a Financial Plan

12 Part One Planning Basics

The advisor reviewed all parts of the plan and was satisfied that the recommendations were integrated and met the needs of the engagement and of the couple’s overall goals. He presented the written document and discussed it with them. He stressed the impor- tance of the recommendations and the fact that no document was worthwhile unless it was implemented. The three set a date for implementing each step. The advisor told them to monitor their progress in savings and to update the document whenever material changes in circumstances occurred such as a large raise or a desire to retire earlier. They set a date for a review in one year and then a more detailed one when they began looking at actual homes. At that time, the investment characteristics and, if necessary, affordability issues would be considered. A diagram of the origins of personal financial planning that summarizes selected material in the chapter is presented in Figure 1.3.

- Consumption and savings - Investments - Capital budgeting - Financing - Risk management

- Cash flow planning - Tax planning - Investment planning - Risk managing - Retirement planning - Estate planning - Special circumstances planning - Employee benefit planning - Educational planning

*Discussed in Chapter 3.



- Time value of money - Cash flow analysis - Optimization - Market pricing - Analysis of risk - Investment models of behavior

- Micro and macroeconomics - Accounting - Law and taxation - Mathematics and statistics - Business and government - Psychology and sociology - Communication and relational skills*



FIGURE 1.3 Origins of Personal Financial Planning

Chapter One Introduction to Personal Financial Planning 13


The Financial Planner Financial planners are the professionals who practice personal financial planning. They are people with designations, education, and experience who are trained to perform the pro- cedures described in this chapter. They generally provide that service to people who wish to improve their financial activities. For example, a person might consult with a financial plan- ner for structuring an investment portfolio or in preparing adequately for retirement. Although other financial people also may give advice in limited areas, a financial planner should always look at a client’s overall financial situation before making recommendations. The formal training to become a financial planner began in 1972 when the College for Financial Planning (CFP) offered education leading to the CFP® or CERTIFIED FINANCIAL PLANNER™ certification. In 1985 the CFP Board of Standards, originally the International Board of Standards for Certified Financial Planners, was established to regulate CFP® practitioners. In January 2000 the two largest financial planning member- ship organizations—the Institute of Certified Financial Planners and the International Association for Financial Planners—merged to establish the Financial Planning Association (FPA; fpanet.org), a national organization of more than 20,000 financial planners. The CFP® certification indicates that a person has been educated in all major facets of financial planning. Candidates must take at least six courses (often including one intro- ductory course) in financial planning including course material on investments, risk man- agement, retirement and employee benefits, estate planning, and taxation and a Capstone Course. Candidates are then required to pass a comprehensive examination and must have at least three years of practical financial experience before qualifying for the designation.

Types of Financial Advisors Various people offer personal financial planning advice today. The term financial advisor, often used by people offering financial advice, has different meanings to different people and groups. To some it means a sophisticated financial planner and to others it connotes anyone who provides financial advice. In this book, we use financial advisor in its broader meaning except for the background sections that describe a financial planning practitioner. Financial advisors include people who identify themselves not only as independent financial planners but also as accountants, lawyers, trust officers, registered representatives, insurance agents, investment advisors, and employee benefit specialists at corporations. Organizations in addi- tion to the CFP-related associations (FPA, Board of Standards) are the National Association of Personal Financial Advisors (NAPFA) for fee-only advisors, whose members are called NAPFA-Registered Financial Advisors; the American College for insurance agents and others who can receive the Chartered Financial Consultant (ChFC) designation; the American Institute of Certified Public Accountants for Certified Public Accountants (CPAs) who receive the Personal Financial Specialist (PFS) designation; and the CFA Institute, which offers the Chartered Financial Analyst (CFA) designation for people who specialize in investments. All but the CFA designation require a broad educational requirement in financial planning.3

As of 2013, more than 500,000 people were providing financial planning services of some sort. Approximately 68,000 held the CFP® certification with hundreds of colleges and uni- versities throughout the United States providing CFP Board–approved educational courses.

What a Planner Does A financial planner is capable of helping people with virtually all of their major financial activities. These activities are embodied in the operating areas of the financial plan. It is necessary to be knowledgeable about all areas because solutions to client problems, even if

3 An explanation of overall practice standards is provided in Appendix I at the end of the chapter, and a detailed description of CFP Board Practice Standards is given in Chapter E on the website.

14 Part One Planning Basics

Financial planning is an exciting career alternative for qualified individuals. It is likely to continue to be so as long as discretionary incomes, especially those of col- lege graduates, rise over time. A career in PFP offers attractive compensation over time and the satisfac- tion of knowing that you can quickly impact people’s financial lives in a significant way. Moreover, clients frequently express their gratitude for your help face to face. The demand for PFPs has increased in response to clients’ need and ability to pay for more complex financial services. This need is anticipated to increase over the coming years and will require increased sophistication by the advisor. Many people lack the time, knowledge, or desire to perform this function properly themselves. Financial planners help people manage their financial affairs. The advisors may offer differing amounts and types of products and services. Some act in a support role while others supervise related financial activities such as investment management. The compensation for these advisors differ. But true financial planners, like doctors, lawyers, accountants, and other profes- sionals, have their clients’ interests at heart. As discussed is the practical comment on integration, perhaps more than anything else, PFPs can be distin- guished by their holistic approach to planning. Even when planning is being done in only one area, the advi- sor will consider information from all facets of the cli- ent’s financial life. In that way the recommendations are efficiently integrated with the client’s own values and circumstances. If desired by the client or recommended by the advisor, a full financial plan will be undertaken. As this book explains, the body of knowledge required is wide and interesting to a broad cross

section of people. The PFP profession can accommo- date varied professional styles ranging from the plan- ner who is a forceful expert manager to one who assists individuals in making their own decisions. Each PFP will find clients that are drawn to their particular style in what often becomes a fairly close relation- ship. As mentioned earlier in the chapter, it is recom- mended that all students, whether you are considering PFP as a career or not, view yourselves as financial advisors. This text is set up to give you the broad tools to do so. Those of you not already enrolled in a program but who want to pursue career opportunities and might be considering a major in PFP can obtain curriculum information from links to the CFP®. The ability to qual- ify for required parts of the CFP® curriculum by taking CFP® required content areas such as personal finance, financial planning or investments in regular college level accredited courses can make it simpler to achieve the CFP®.4 To assist in making a career decision after taking this course, you should apply for part-time internship positions at relevant businesses. Those of you who are taking a one-time course can be financial advisors for yourselves and be more knowledgeable individuals in your future interactions with financial professionals. All readers should find this information and analytical approach surprisingly useful in financial and for more information on PFP as a career see Web Chapter D. other courses that follow.

4 Approval subject to compliance with CFP Board required coverage of relevant coursework. See CFP Board education requirements regarding transcript review for further details at http://www.cfp.net/ become-a-cfp-professional/ cfp-certification-requirements/education-requirement/

Professional Advice Attractiveness of a PFP Career

pertaining to only one activity, must take into account a client’s entire financial situation. However, a large number of financial planners specialize in one or a few financial planning areas. Examples of the activities that financial planners commonly help people with include:

• Constructing a comprehensive financial plan.

• Selecting an overall asset allocation and individual investments.

• Establishing and implementing risk management–insurance parameters.

• Structuring and planning household cash flows.

• Eliminating debt difficulties.

• Helping plan for retirement.

• Setting up an estate plan.

• Developing goals.

• Reducing taxes through planning, products, and structures. • Becoming knowledgeable about financial matters.

Chapter One Introduction to Personal Financial Planning 15

Life Cycle Planning Intro to PFP

College Age • Start the process of understanding your financial situation. By selecting this book and enrolling in this course, you are on your way.

• Develop a well-rounded balance of educational, social, and personal activities.

• Think about how to make “healthier” financial choices. For example, watch out for debt.

• Try to sketch out a post-graduation plan.

• Welcome to the group, if you are anxious or uncertain about money. Some education should help. Lighten up!

• Prepare to think of yourself as running a small business, your household.

Twenties • Take charge of your household as if it were a business. This is a continuous theme of this book.

• Attempt to add one healthy financial practice, such as knowing your annual expenses.

• Begin to make more affordable purchasing decisions.

• Outline your career goals.

• Act as head of your household business and strive to be as efficient as possible now that you have a job and your own residence.

Thirties • Continue to treat your household like a business. If you think logically you will profit from it. Impulsive acts should be kept to a minimum.

• View yourself as an integral part of the household business—exercise and reduce stress to make sure your “business” takes hold.

• Sketch out a financial plan on paper at least in bullet point form if you haven’t already done so.

• Focus even more seriously on appropriate family matters. Include your loved ones in family


Forties • Appraise where you are versus where you want to be and be open to mid-course corrections.

• Construct a detailed financial plan and try to follow it.

• Make sure you have accumulated significant financial assets, particularly in relevant accounts, or alter your savings habits.

Fifties • Place more emphasis on retirement planning, calculating the amount of annual savings you will need to fulfill your retirement goals.

• Carefully follow the plan for reaching those goals.

• Think about and plan any lifetime nonfinancial goals.

Sixties • Make sure you are financially ready for approaching retirement or prepare to work longer.

• Plan estate considerations if you haven’t done so already. Shame on you on behalf of your loved ones if you don’t have a will.

• Decide whether you want to retire “cold turkey” or gradually lessen your workload. Find out how your employer feels about switching to part-time work.

• Think about where you will live after retirement.

• Try to broaden your interests to keep physically and mentally active after you stop working.

Seventies and Beyond • Congratulations! You have finally made it.

• Review your estate plan, making changes where appropriate.

• Remain socially and mentally active.

• Keep yourself physically fit. Tai chi, anyone?

The following presents action items related to each relevant chapter from a practitioner’s standpoint. Since many essential individual action items change over a life cycle they are presented by age. It is provided in a simple less formal style.

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16 Part One Planning Basics

Example 1.2 The role that a financial planner plays is somewhat similar to that of a doctor. The doctor may be a general practitioner (GP), a professional who is familiar with most common patient medi- cal problems. When the ailment is less common or could otherwise benefit from a more con- centrated focus, the person is referred to a specialist. Often the GP maintains the role of the patient’s principal medical advisor. Many doctors specialize in a particular type of medicine. Although their patients come to them for a particular ailment, they must be familiar with the workings of the entire body. That is true because the symptoms may come from their specialized area, but the cause may lie elsewhere. You may see a financial planner for a comprehensive financial checkup or financial plan, as you would a doctor for a comprehensive physical checkup. Or you may have a particular concern to discuss. In each case the overall state of your health, whether it be financial or physical, must be kept in mind.

For many reasons, including being involved in challenging, rewarding activities, personal financial planning is a popular career path with an increasing number of students selecting it as an undergraduate or graduate major. Financial advisory jobs are expected to be among the faster-growing occupations in the United States with a projected growth rate of 32 percent between 2010 and 2020, according to the Bureau of Labor Statistics. During that time frame, 66,400 jobs are expected to be added to the 206,800 jobs that already existed.5

Back to Dan and Laura The following case study is developed throughout the book with the relevant material pre- sented at the end of each chapter. Both the facts and interpretation of each meeting are presented through the eyes of the financial planner doing the advising.


Dan and Laura, who became my clients in January 2015, came into my office. They brought along their new baby son, Brian. Laura mentioned that because Brian was so young she was reluctant to leave him in anyone else’s care. A discussion about Brian seemed to help both Dan and Laura unwind. We then proceeded to talk about both of their backgrounds. Laura, 35, grew up in a comfortable middle-class neighborhood, the only child of an owner of a successful sporting goods store. She was raised in a home in the suburbs and had all the comforts she wanted. She went to a private, all-women’s college where she majored in English. She took a position as a public school teacher when she graduated. She is currently on maternity leave of absence arising from Brian’s birth and is unsure when she will return to work. I noticed that Laura’s body language seemed relaxed and natural. Even though her baby started to cry from time to time, she maintained her participation in the proceedings. In contrast to Laura, Dan still did not seem to be completely engaged. His face seemed strained, his eyes half closed when he spoke, and his arms were folded. I decided to turn my attention to him. Dan, 35, is one of four children. His mother and father both immigrated to this country. Household finances were very tight. Both parents worked, and Dan’s father often had two low- paying jobs. Dan remembers the time that his Dad was laid off and they were almost forced to take a smaller apartment in which Dan would have slept in the living room with his brother. Despite that trouble, Dan described his family life as happy and himself as always having been a “worrier” when it came to money. Dan worked part-time as a teenager and went to a state university where he borrowed the entire sum for room and tuition. He studied computer science

5 Jada A. Graves, U.S. News & World Report, December 18, 2012, money.usnews.com/careers/best-jobs/ financial-adviser

Chapter One Introduction to Personal Financial Planning 17

in college and is currently working as a systems engineer for a computer service company. His job involves above-average risk because he works for a firm on a multiyear project but could be terminated after it is over. On the other hand, he is well compensated for his efforts. In fact, the immediate reason that Dan and Laura came to see me was that they had $20,000 in credit card debt. They had accumulated this debt as the result of higher household expenses and a desire not to touch their marketable investments. They wanted to eradicate the debt as soon as possible. I made a mental note that the debt seemed inconsistent with Dan’s worries about money but decided not to discuss this until later. I told them that I would create a debt repayment plan, but first I wanted to collect some data on their accumulated assets, other liabilities, and goals. The fact that Dan was able to discuss his background and his concern about his debt and that I treated the problem in a matter-of-fact way seemed to lift his spirits. He became more relaxed, turned directly to the table, and even smiled once or twice. The couple had accumulated about $10,000 in pension assets, $34,000 in money market funds, $103,000 in stocks and stock funds, and had $2,800 in a checking account. More broadly speaking, they had $3,000 in current assets and $147,000 in marketable invest- ments. They owned two used cars worth $6,000 each. Their furniture and fixtures were valued at $7,000. Dan had a stamp collection worth about $1,000, and Laura had jewelry worth $4,000. In addition to $20,000 in credit card debt, they had a total of $46,000 in student loans and $20,000 in loans from parents. Next we turned to the couple’s goals. Their most immediate goal was to lift the pres- sure created by their debt. They believed that their current lifestyle was fine and saw no need to raise it. They wanted to have one more child. As Laura said, she always felt lonely as an only child, and Dan liked having siblings. She thought that Brian would want one too. She and Dan believed their current two-bedroom apartment was sufficient for one child but wanted to own their own home. They wanted their insurance checked for adequacy. They were placing money in retirement savings accounts but felt that it wasn’t diversified properly. Dan and Laura had ambitious retirement goals. They wanted to be financially indepen- dent by age 55. In retirement they wanted to maintain their current lifestyle and thought their costs would stay the same as when they were working. In addition, they wanted each child to be left $100,000 in inflation-adjusted terms. Finally, their objective was a plan that laid out their goals, indicated whether they were realistic, and, if so, would provide guidance in achieving them. I explained to them that they had basically described the function and scope of a finan- cial plan. I indicated that the recommendations would reflect their goals and what I believed should be their focus. Laura mentioned that given her preoccupation with her baby, she would prefer frequent meetings by topic rather than in-depth interviews. I gave them a questionnaire to help them focus and to obtain further financial information. The goals, time frame, and cost were set. At just that moment, Brian started to cry loudly and the first meeting was over. I decided to prepare each section of the financial plan discussed after each meeting, and I told them I would send a draft subsequent to the session for them to examine. I rec- ognized that parts of the plan would have to be revised once the total costs of their goals were compared with current and future cash inflows. The introduction to financial plan- ning could be completed right now.

This is how I introduced Dan and Laura to financial planning: Personal financial planning is the process of supervising your financial activities so that you can meet the goals you have set out. In order to accomplish those goals, it is helpful to con- struct a financial plan. This document will consider your goals overall, compare them with your current and future resources, and establish a plan for attaining them. In addition to

18 Part One Planning Basics

outlining your goals and current assets, the plan consists of the following active areas: cash flow planning, tax planning, investments, risk management, retirement planning, estate planning, educational planning, employee benefits planning, and special circumstances planning, sometimes incorporated in other sections for all else that is financially relevant. Let me explain the financial planning process I would perform for you. After our pre- liminary interview we will have established the scope of the activities to be completed. In your case, as mentioned, it is a full financial plan. Based on that engagement, we will gather the data and identify goals. I would have already provided you a copy of my ques- tionnaire to supplement the data gathered in our face-to-face meeting. After that process is completed, we will accumulate and analyze the data. It will be comprehensive, encompassing all major parts of the plan as already indicated and any oth- ers we decide are important. At that point we will develop solutions, which will be inte- grated, meaning they will combine all parts of the plan, giving you what we arrive at as the best use of your money. Given your preference, each part will be discussed separately. Nonetheless, we will have a completed financial plan presentation at the end of the process and a meeting to go over the plan. Planning does not end there. The plan will have to be reviewed and updated periodically. We will construct your financial plan with your goals in mind. As indicated, we will discuss each part of the plan separately and I will develop each. I will explain why I make my recommendations in enough detail so that you can provide me your reactions prior to the final integration stage for completing the plan. We are off to a good start, and I look forward to helping you achieve your goals.

College Student Case Study and Review: Amy and John This case study presents an overall chapter review as an advisor answers the questions of two undergraduate students. It provides the chapter material in a simplified and less for- mal way than most of the book. Some of the material is presented through dialogue and is focused on the facts that college-age adults consider more interesting and more relevant in support of the goals of the course and of the professor. That means that, in relevant chapters regardless of age, you can use this case of Amy and John to help absorb the chapter material. This approach is beneficial whether you employ it prior to beginning the chapter or more commonly afterward as a chapter summation.

BACKGROUND At first it was awkward. Amy says she and her stepbrother John were “thrown together” as stepsiblings by the whirlwind courtship and marriage of their mother and father respectively. Amy’s father died prematurely when she was only 10 years old. Fortunately, between her mother’s successful accounting job and a large insurance payout, Amy grew up comfortably. John’s mother and father had divorced four years earlier. His relationship with his mother was close, but he was even closer to his father and chose to live with him. Although alimony payments restricted some discretionary household expenditures, his father, a midlevel ex- ecutive, made enough money for John to feel he led the same lifestyle as his friends. Their parents’ marriage changed some things. Amy’s mother lost her job in the recession of 2009 and was forced to accept a lower-paying one. Because of his firm’s economic difficul- ties, John’s father’s wages were recently frozen. The result was more emphasis on household budgeting and both John and Amy were forced to take on debt to finance their college costs.

Chapter One Introduction to Personal Financial Planning 19

The combination of “inheriting” a new parent and a new sibling was uncomfortable for both John and Amy. The new siblings were almost exactly the same age but had little else in common. Amy was a cheery, talkative, optimistic young woman. Although fundamen- tally intelligent, she had little time for analysis and was very direct in telling people to get straight to the point unless it pertained to boys or fashion. John on the other hand was fairly quiet, almost introverted. He liked analysis and did well in math classes and other subjects that he found interesting. He was somewhat con- cerned about his future, but he also liked to party and was a big sports fan. At first, living under the same roof was awkward and overly polite for both John and Amy, but gradually they relaxed and bonded over shared family experiences. Over time, they became closer and even went on double dates with each other’s friends. Both were beginning seniors in college and would soon be setting up their own house- holds. Amy thought she might pursue a career doing something creative, perhaps in fash- ion. John was knowledgeable in finance and in addition to doing his own personal financial planning, he wanted to investigate it as a possible career. Fortunately, their parents gave them a series of meetings with a professional financial planner as a birthday gift. Amy said that while she had no objections to a male planner she thought she could relate better to a female one. John said he was indifferent to the plan- ner’s sex, he just wanted one that would be good. After an investigation they both selected a female advisor. They were enthusiastic about the meetings and were happy that they had a planner, who in addition to being highly qualified they thought had a sense of humor. Both came to the meetings with questions geared toward PFP and listened to the planner’s responses. In the meetings, Amy asked many basic questions because of her lack of experi- ence and interest in PFP. John, being more knowledgeable, attempted to help his stepsister and also asked more analytical questions. In each case, the planner presented his thoughts as the discussion unfolded.

Current Background I was impressed with both Amy and John. They were both fairly intelligent and lively people. While John hesitated before speaking, Amy was outspoken, laying her feelings and beliefs on the table. She candidly opened up our conversation by asking me why she should pay attention to financial planning because she felt she hardly had a need for it now. She also asked me whether her parents, who had spoken to me once recently, thought she had frivolous spending habits and invited John so that she could mimic his more responsible financial habits. I assured her that was not the case. I told her that personal financial planning was an activity that would be useful through- out their lives. It would allow them to be more sophisticated purchasers of goods and ser- vices. Its usefulness would become apparent once she began working and established her own household. I impressed on them that I would not only present them with useful facts but also show them how to analyze and reach conclusions on their own. I told them that they were now advisors in training so that they would get the most out of our discussions by becoming more involved and drawing more informed conclusions.

Understanding Financial Planning This first session would introduce them to the topic. I explained that the easiest way to com- prehend PFP is by understanding finance terms. Personal finance is the study of cash flows that support their activities and provide for their well-being. Household finance is similar to personal finance but may place more emphasis on individual households. Each calls on many different disciplines ranging from micro- and macroeconomics to accounting, law, taxation, mathematics and statistics, business and government, psychology, and sociology.

20 Part One Planning Basics

Personal financial planning analyzes personal finance in four areas: consumption and savings, investments, financing, and risk management. I mentioned that I would often use a variation of the following process approaches to explain the topic:

1. Establish the scope of the activity. 2. Gather the data and identify the goals. 3. Compile and analyze the data. 4. Develop solutions and present the plan. 5. Implement the plan. 6. Monitor and review the plan periodically.

The financial plan incorporates all goals and maps out how to reach them. Its common segments are establishing goals, analyzing financial statements, cash flow planning, tax planning, investment planning, risk management, retirement planning, estate planning, special circumstances planning, employee benefits, and educational planning. I stressed that what distinguishes financial planning from other forms of financial advice is its inte- grated approach. That is, it integrates all the goals and needs into every part of a plan to create an overall solution. That solution merges ideal lifestyles with the realities of how much money will be available to finance those lifestyles. Amy asked what happens when your projected life cycle money falls short of needs. I said that there is a compromise in goals such as considering earning more money, retiring later, or more often, cutting back on less important expenditures.

Financial Planning as a Career I glanced at John as I moved on to financial planning as a career. I explained that financial planners assist others with their financial goals and needs and that a variety of organiza- tions provide such services. Many people are attracted to PFP as a career because planners can really help people with their financial lives, receive genuine thanks, and make a sig- nificant living. A selection of some of planners’ most sought after services include planning for retire- ment, improving investment returns, structuring budgeting and other cash flow matters, setting up estate plans, tax reduction, controlling risks, and integrating all major financial needs into a comprehensive financial plan.

John found the information to be useful given his possible career interest. However, Amy seemed to be in and out, fiddling with her phone during the career discussion. Both agreed to think of themselves as financial planners in all subsequent meetings.

Summary The chapter introduces personal financial planning (PFP) and its process for your prelimi- nary examination.

• PFP is the method by which people anticipate and schedule their future activities to reach their goals. It is the action stage of personal finance.

• PFP is a six-step process that begins with establishing the scope of the activity and ends with monitoring and reviewing the plan as set out.

• The financial plan is a practical structure for achieving the goals set out. A comprehen- sive financial plan incorporates all relevant financial areas including cash flow, tax, in- vestment, risk management, retirement, estate, special circumstances, employee benefits, and educational planning.

• Financial planning is a growing career opportunity that helps people in a wide variety of their financial pursuits.

Chapter One Introduction to Personal Financial Planning 21

Key Terms capital, 5 cash flow, 5 cash flow planning, 9 comprehensive financial plan, 9 educational planning, 10 employee benefits, 10 establishing goals, 9 estate planning, 10 fair value, 5

finance, 5 financial advisor, 13 financial plan, 8 financial planner, 13 financial statements, 9 household finance, 6 investments, 5 market structures, 5 market value, 5 markets, 5

personal finance, 6 personal financial planning, 6 retirement planning, 10 risk, 5 risk management, 9 special circumstances planning, 10 tax planning, 9

cfp.net CFP Board This is the website of CFP Board of Standards, the institution that offers the CFP® exam. It provides information about the CFP® exam and related courses, the financial planning profession, and information on finding a CFP® practitioner. The site also contains links to request a free kit on financial planning and report a complaint against a CFP® practitioner.

fpanet.org Financial Planning Association (FPA) This is the Financial Planning Association’s home page. It features financial re- sources for financial planners and people interested in earning the CFP® certification. You can also find a link to the Journal of Financial Planning, the CFP® practitio- ner’s journal.

napfa.org National Association of Personal Financial Advisors (NAPFA) NAPFA, set up exclusively for fee-only financial planners, has a website that con- tains links for both the public and professionals. Among featured services are finding a fee-only financial planner, consumer tips, press releases, member resources, and career center.


Questions 1. Why did it take until the 1970s for the field of financial planning to begin? 2. Why does personal financial planning involve other disciplines as shown in Figure

1.3? Give some practical examples of their use.

3. What are the differences between financial planning and a financial plan?

4. Describe the personal financial planning process and relate it to planning procedures.

5. Contrast a segmented and a comprehensive financial plan.

6. Describe some similarities and differences between a financial planning practitioner and a physician.

7. Why is integration so important in financial planning?

8. List and discuss the parts of a financial plan.

9. Sam went to a financial planner who proceeded to give him written recommendations in all areas of financial planning. Is that a financial plan? If not, what might be missing?

10. What does a financial planner do?

11. Name some common financial problems with which planners deal with.

12. How do you think the financial planner will be of the most help to Dan and Laura? Be specific and explain why.

22 Part One Planning Basics

13. What is a contributing factor for the increasing demand for financial planners?

14. Do you think the amount of information available on the Internet regarding advice for financial planning is beneficial or detrimental to the financial planning career? Support your answer with information from the chapter.

15. Do you believe Maria needed a financial planner? Why or why not?

16. How does household finance tie into financial planning?

CFP® Certification Examination Questions and Problems

You receive a phone call from someone you have not spoken to recently. The caller is ex- cited, having just heard that a brand new mutual fund is positioned to deliver large gains in the coming year. The caller wishes to purchase shares of the fund through you. Keeping in mind the stages of the overall personal financial planning process, which of the following questions that address the first two stages of financial planning should you ask?

1. What are your goals for this investment?

2. What other investments do you have?

3. What is your date of birth?

4. Do you want the dividends reinvested?

a. (1) and (3) only

b. (2) and (4) only

c. (1), (2), and (3) only

d. (1), (2), and (4) only

1.2 Arrange the following financial planning functions in the logical order in which these functions are performed by a professional financial planner.

1. Interview clients, identify preliminary goals

2. Monitor financial plans

3. Prepare financial plan

4. Implement financial strategies, plans, and products

5. Collect, analyze, and evaluate client data

a. (1), (3), (5), (4), (2)

b. (5), (1), (3), (2), (4)

c. (1), (5), (4), (3), (2)

d. (1), (5), (3), (4), (2)

e. (1), (4), (5), (3), (2)


Chapter One Introduction to Personal Financial Planning 23

Case Application This case allows students to develop solutions themselves. It begins with an extensive background that will assist in the decisions that are asked for in subsequent chapters.

BACKGROUND—FIRST INTERVIEW Brad and Barbara arranged to come in to see me. They were both young college graduates and arrived wearing jeans and T-shirts. I soon found out they were recently married and lived with Brad’s parents, Richard and Monica, in the basement of the their house. Brad and Barbara paid for all of their own expenses. His parents got along extremely well with Barbara and treated her as one of their children. Recently the relationship between them had been deteriorating. When they weren’t ar- guing, they were whispering to each other. Both Brad and Barbara had overheard some of their conversations, which seemed to be about money and investing. Brad was very close to his uncle Tim and asked his advice about the situation. He suggested that Brad and Barbara recommend that their parents see a financial planner. Tim thought Brad and Barbara should meet the planner prior to discussing their recom- mendation with their parents. He had one advisor in mind. Tim said that Brad’s parents were both educated and unusually open in their discussions. Brad and Barbara should relay to the parents their concerns, including the fact that the parents’ problems were beginning to affect their own lives. Tim said that Brad and Barbara should suggest handling the finan- cial concerns as a family problem that could be worked out together, one that could bring the four of them closer. He was sure they would respond favorably. In fact the uncle was correct. My meeting with Brad and Barbara was very constructive, and I gained insight into the parents. Thereafter, Richard, the father, called and made an appointment. Interestingly, he mentioned that Brad and Barbara had some financial issues themselves. The detailed planning was to be done for the parents, but the engagement also would cover any planning that Brad and Barbara wanted done. Richard walked tentatively into my office early one evening. He glanced around ner- vously and closed the door behind him. I could sense that there was no need for small talk. He wanted to tell me his story. Richard, age 58, told me he had grown up in a small town and had married the high-school prom queen. He described Monica as a sweet and caring wife, as beautiful at 54 as she was at 18. He indicated that she would be devastated by his news. He became choked up, and we paused for a minute. The news was that he had lost $200,000 in a speculative investment. He mentioned that his $550,000 in retirement assets was down to a current figure of $350,000. He asked me to help them without telling his wife of the loss. I told him that if I took an assignment that involved two people, there would have to be honesty all around. He mentioned again that he thought she would be devastated. My response was that even if we hid it, the true story would come out even- tually anyway. I thought that he and Monica should come in next and we would start the process. At our next meeting, Richard came in first, and we waited for Monica. She entered the room, a tall, elegant woman with a ready smile. We engaged in some small talk, and after a time, I stated that Richard had something to say. When he broke the news, she was not as frail and sensitive as Richard had feared. She was visibly shaken but said their recent argu- ments over money had made her suspicious. She then asked how we could “make it up.” I indicated I would help but first wanted some particulars. Richard was a lawyer who worked in the entertainment industry. When he got out of college, he wanted to be a rock star, but his parents persuaded him to do something “more substantial.” Monica had gone to a state school and majored in English. She did a little writing but spent most of her time raising her children when they were young and the rest of it now in community activity.

24 Part One Planning Basics

They had married when Richard finished college and Monica graduated from high school. Their graduation ceremonies took place on the same day, and fortunately they were able to make both. They had two children, son Brad and a younger daughter Stacy. Both were married, but Stacy and her husband were separated, and Richard and Monica were helping her pay her bills. The couple indicated that they were saving about $20,000 a year gross but admitted that vacations and special expenditures came out of that pool. They wanted to retire when Richard turned 65. In retirement, they wanted the same lifestyle that they currently had. They did mention that it didn’t have to be in the high- cost metropolitan region they lived in then; it could be in a retirement community in Arizona. They wanted to make sure that Stacy was given at least $10,000 per year in i ncome once they passed away. They had approximately $200,000 in life insurance on Richard’s life. They wanted a total review of their assets and to examine the sensibility of that the age 65 retirement. I looked around and Richard seemed relieved that Monica had fully recovered.

Case Application Questions 1. What do you think of Brad and Barbara’s seeking help for Brad’s parents?

2. What prompted Richard to seek assistance? Was it only because of Brad and Barbara?

3. What type of financial plan seems appropriate for Richard and Monica?

4. Why do you think Monica didn’t react more negatively to the financial news?

5. What might the loss tell you about Richard?

6. Do you think I should have met privately with Richard? Why?

7. Complete the introductory section of the financial plan.

Appendix I

Practice Standards Practice standards are the methods by which professionals establish acceptable ways of performing their occupation. These standards are particularly important for financial plan- ners because of the significant role that financial advice often has for achieving client goals. In addition, adhering to high principles can reduce the chance of being sued, and complying with proper practices can be a defense against litigation in the event of loss. Finally, well-thought-out and executed practice standards can differentiate a true profes- sional from the array of people who may call what they do financial planning. Practice standards begin with establishing the client relationship and extend to gather- ing data, analyzing the client’s financial situations, developing and presenting recommen- dations made, and providing for implementation and monitoring. A detailed presentation of CFP Board Practice Standards, along with its Code of Ethics, is provided in Chapter E of this text on the website.


Chapter Goals

This chapter will enable you to:

• Develop a working understanding of compounding.

• Apply time value of money principles in day-to-day situations.

• Calculate values for given rates of return and compounding periods.

• Compute returns on investments for a wide variety of circumstances.

• Establish the effect of inflation on the purchasing power of the dollar.

Dan and Laura e-mailed me and asked if they could set up a meeting to discuss some prob- lems that had come up. I noticed the stern look on Dan’s face as they walked in. They were having a disagreement that they said was about paying government taxes early. Laura wanted Dan to claim seven dependents on his withholding form at work. That would, of course, lead to a higher amount of available cash during the year. I suspected that their argument was not only about early payments and the time value of money but also about their different beliefs about spending cash.

Real-Life Planning

June had an ever-present wide smile and looked 10 years younger than her age. This was true even though her husband had died when their children were young, and she had raised them by herself while holding down a full-time job. Her children were all grown now and on their own. As she explained it, they had met and decided to recommend that she see a financial planner. They wanted someone to re- view the performance of their mother’s account. The same financial advisor had managed that account for 25 years. He was such a “nice fellow” and she was one of his first ac- counts. He had done “so well by me,” she said; he had invested the $200,000 proceeds from her husband’s life insurance policy, putting it all into stocks, and turned it into $500,000 currently. Moreover, she was able to save $5,000 each year and now that sum invested in stocks with the same broker was worth $150,000. She didn’t know why her children wanted her account reviewed. The advisor was shocked by the investment results. They indicated a return of 3.7 percent annually for the lump sum and 1.5 percent annually for the yearly deposits. He asked June a second time whether any withdrawals had been made and was told no.

Chapter Two

The Time Value of Money

26 Part One Planning Basics

During that 25-year period, stocks with the same risk characteristics had increased 12 percent a year. If she had earned a market rate of return, her $200,000 lump sum would now be worth $3,400,000 and her $5,000 deposits would have increased to $667,000. The advisor decided not to tell June that her current combined accumulated retirement sum of $650,000 could have been worth more than $4,000,000 today. It would have been too upsetting. He would mention that only if she failed to grasp how poorly she had done. Instead he discussed basic time value of money concepts with her. He explained how compounding over extended periods of time can make weak results look favorable. He said that the $300,000 gain from the lump sum was one such instance and that calculating the compounded rate of return was the appropriate approach to use. He told her that many people made mistakes in decisions because of these compounding distortions. He indicated that her results were very weak and that average results could have placed substantially more money at her disposal today. In fact, the results were so weak that in inflation- adjusted terms, her returns were negative. In other words, instead of increasing, her sums, in purchasing-power terms, were worth less than at the time they were originally deposited. The advisor indicated that he was using standard time value of money concepts for lump sums and annuities. They were objective calculations that could speak for them- selves. He then handed her those calculations. June looked at them, then stared straight at the advisor and asked, “What do we do now?” This chapter will enable you to understand time value of money concepts. You will be able to calculate returns yourself, often simply, for example, in June’s case.


Financial planning entails making decisions from choices presented. Among the alterna- tives are spending today versus saving for the future, selecting one investment over another, or deciding on the future amount of money needed for retirement. All of the choices use time value of money principles to determine the correct decision. Without these principles, you couldn’t compare the choice of $1.00 today with $1.20 in, say, six years. In this chapter we examine the time value of money, its major principles and methods. We start with compounding and then discuss finding the present value, the future value, and the discount rate and the concept of annuities. You will learn about the importance of differing rates of return and time to compounding, how to handle irregular cash flows, and the effect of inflation on figures and serial payments. The next time someone offers you a choice of income payments over, say, three years, or higher payments over four years, you will be able not only to determine definitively the best choice but also to compute the values for each alternative. The overall objective, then, is for you to be able to use time value of money techniques whenever appropriate to make correct PFP decisions.


The time value of money can be defined as the compensation provided for investing money for a given period. In sum, under the time value of money, your money has differ- ent values at different points in time. If you were offered the choice of $1,000 today or $1,000 two years from now, you would opt for the money today. That is because you could invest the money and in two years have much more than the original $1,000. From another perspective, what is known as the time value of money is the benefit of having the use of money sooner rather than later.

Chapter Two The Time Value of Money 27

Example 2.1 Suppose that Stacey Anderson finishes her education, goes on a round of interviews, and accepts a well-paying job offer. She wants to make a good impression, right from the begin- ning, so she goes shopping for a new car. Stacey finds an appealing vehicle (attractive, practical, fuel efficient) and negotiates a $36,000 purchase price with the dealer. “I can’t pay $36,000 now,” Stacey said, “but I can afford to pay you $750 a month. That’s $9,000 a year, so I’ll pay for the car in four years.” That might be a good bargain for Stacey but not for the dealer. By accepting, the dealer would be extending a no-money-down, interest-free loan to Stacey. The dealer would rather be paid in full, upfront. Therefore, the dealer insists that Stacey put some money down and borrow the rest of the $36,000 purchase price upon which they had agreed. If Stacey borrows from a third party, the dealer will get cash and have the use of the full $36,000 immediately; if the dealer extends a loan to Stacey, interest will be payable. Either way, if Stacey wants the use of that $36,000 now—so she can drive the chosen car to her new job—she will have to part with some of her own cash and pay interest to a lender for advancing her the balance.

Compounding Compounding is the mechanism that allows the amount invested, called the principal, to grow more quickly over time. It results in a higher sum than just the interest rate—or rate of return on your investment—multiplied by the principal. Once you compound for more than one period, you receive not only interest on principal but interest on your interest. In your multiplication, you add 1 to the interest rate to get the end-of-period value. See the following examples:

1. One-period compounding:

Principal beginning of year: $2,000

Interest rate: 10%

Principal end of year 1 = $2,000 × 11 + Interest rate2 = $2,000 × 11 + .102 = $2,000 × 1.10 = $2,200 2. Two-period compounding:

Principal beginning of year: $2,000

Interest rate: 10%

Principal end of year 2 = $2,000 × 11 + Interest rate2 × 11 + Interest rate2 = $2,000 × 1.10 × 1.10 = $2,000 × 1.21 = $2,420 Were it not for the compounding, or interest on interest, we would have taken a simple interest rate for two years, 1 + .10 + .10 = 1.20:

$2,000 × 11.202 = $2,400 The $20 difference between $2,420 and $2,400 represents the interest on interest. By com- pounding for long periods of time, the interest on interest can amount to a huge sum. Think of a small snowball rolling down a snow-covered mountain. As it moves along it gets larger, not primarily because it is placing snow on the original small snowball but because it is placing snow on top of an ever-larger snowball. That is the equivalent of interest on interest. By the time the snowball hits the bottom of the mountain, it can become a boulder capable of crushing anything in its path.

28 Part One Planning Basics

Legend has it that Native Americans were paid $24 for Manhattan Island in the year 1626. If that was the case and the sellers had placed that money in a blend of bond and stock investments returning 8 percent a year, they would have had more than $220 trillion by the year 2014. They would have had enough money to buy the Brooklyn Bridge and probably all the buildings that could be seen from the top of it. Let’s do a calculation using that $2,000 investment that shows the effect of compounding at a 10 percent interest rate for five years. Notice in Table 2.1 that the compounding contribution has gone from $20 at the end of two years to a cumulative sum of $221 by the end of five years. Note that the total contribution of compounding over simple interest at the end of five years is $221, which is more than one year’s worth of simple interest. The cumulative gain turns out to be more than 60 percent of the beginning principal as compared with 50 percent for simple interest. A comparison of simple interest relative to compounding for a cumulative 5-year and 20-year period is given in Figure 2.1. At the end of 30 years, the amount of simple interest would be insignificant relative to the compound interest. This is illustrated in Figure 2.2.

Using a Financial Calculator In many of the problems that follow, you could receive your answer by looking up a com- pounding factor in a financial table, but that is hardly efficient. Many financial calculators can


Beginning Principal



Simple Interest Income

Compound Interest Income

Compounding Contribution

1 $2,000 $2,200 $200 $200 $0

2 $2,200 $2,420 $200 $220 $20

3 $2,420 $2,662 $200 $242 $42

4 $2,662 $2,928 $200 $266 $66

5 $2,928 $3,221 $200 $293 $93

Total $1,000 $1,221 $221

TABLE 2.1 Impact of Compounding— Investment of $2,000

$1,000 $1,221








In te

re st




simple compound simple compound

5-year 5-year 20-year 20-year


FIGURE 2.1 Comparison: Compound Interest versus Simple Interest

Chapter Two The Time Value of Money 29

perform the operation for you. In fact, all financial calculators generally use the same basic keystrokes. They often have special keys to calculate the time value of money and perform many other financial operations. Five special keys—N, I/Y, PV, PMT, FV—allow you to solve all the simple time value calculations in this chapter.1 They are presented in Figure 2.3.

N = Number of years or compounding periods I/Y = Rate of return on an investment or discount rate PV = Present value PMT = Periodic payment FV = Future value

We will use a form of this “all calculator” diagram to solve for all simple time value type problems throughout the book. Basically, as you will see, you enter all the inputs and press the key for the variable you are solving for. Unfortunately the calculators diverge in their approach to more complex financial problems.2 In these instances, we have selected two leading financial calculators—the HP12C and the TI BA II Plus—for which we will supply the individual keystrokes. In Appendix II to this chapter, you will find details on performing the same calculations in Excel.

Present Value The present value of a sum is its worth at the beginning of a given period of time. We may be offered an amount of money in the future and want to know what it is worth today. In other words, we want to know its current value. In financial terms, we call this being given the future value and having to solve for the present value. The amount is obtained










1 6 11 16 21 26 31


C um

ul at

iv e

In te

re st

Compound interest income

Simple interest income

FIGURE 2.2 Comparison: 10 Percent Interest—Simple versus Compound

1 Note that HP12C uses i instead of I/Y notation. 2 Our complex problems are mostly internal rate of return (IRR), which will be explained later in this chapter, and net present value (NPV), which is explained in Chapter 8.

N I/Y PV PMT FV FIGURE 2.3 Financial Calculator Keystrokes

30 Part One Planning Basics

through discounting that future value by an appropriate discount rate. In effect, discounting is like compounding in reverse. Just as you may have been surprised at how large a sum of money grew through compounding over many years, you may have the same response to the results of discounting. However, in this case, your surprise would be at how small the present value is relative to the future value when discounting occurs over many years. The formula is:


11 + i2n Note: In entering figures or receiving solutions, remember to record cash received as a positive figure and cash payments as negative ones. For the HP12C, mark the negative amounts with the keystroke CHS; use +/– for the TI BA II Plus. Always remember to clear the financial register before starting a new problem (HP12C—press the keystroke f and then FIN; TI BA II Plus—press 2nd , RESET, and ENTER). Also keep in mind that depending on the procedures you follow (for example, the number of decimal points entered), your calculation may differ slightly from the example provided. Generally, those differences are not important.

Example 2.2 What is the present value of $3,270 to be received one year from now if the discount rate is 9 percent?

PV = 3,270

11 + .0921 = $3,000

Inputs: 1 9 3,270

Solution: –3,000


Note: The present value figure is negative because $3,000 would have to be paid today to receive $3,270 in the future.

Example 2.3 What is the present value of $223,073 to be received 50 years from now if the interest rate is 9 percent (see Figure 2.4)?

PV = 223,073

11 + .09250 = $3,000

Inputs: 50 9 223,073

Solution: –3,000


Calculator Solution

Calculator Solution

FIGURE 2.4 Present Value

Year 0 i = .09 1 i = .09 2 i = .09 3 49 i = .09 50


Chapter Two The Time Value of Money 31

Future Value Future value is the amount you will have accumulated at the end of a period. The sum accumulated depends on the amount you invested at the beginning of the period, the inter- est rate, and the number of years and compounding periods involved. It is given by the following formula:

FV = PV11 + i2n

Example 2.4 If you were to deposit $7,000 in a certificate of deposit for five years earning 5 percent annu- ally, you would have $8,934 accumulated at the end of the period (see Figure 2.5).

FV = 7,000 × 11 + .0525



5 5 –7,000



The future value of a lump sum is simply the present value equation given in the previ- ous section rewritten. The future value of a sum compared with its present value depends to a great extent on the rate of return on the investment. Clearly, the higher the rate of interest, the higher the sum you accumulate at the end of the period. Given the power of compounding, a relatively small difference in the rate can make substantial differences over longer periods of time. Figure 2.6 shows these differences.

Calculator Solution

FIGURE 2.5 Future Value

Year 0 i = .05 1 i = .05 2 i = .05 3 …. 4 i = .05 5

–$7,000 $8,934











5% 8% 10% 15% 20%


Fu tu

re V

al ue

FIGURE 2.6 Future Value at Alternative Rates of Return (Payment of $1,000 for 20 years)

32 Part One Planning Basics


The interest rate for compounding or discounting and the number of time periods are the key variables for determining accumulated sums given a fixed amount deposited. As you will see, a shift in either compounding time or interest rate, even when relatively modest, can have a material effect on final results. In the following sections, we demonstrate that sensitivity in our description of the use of the rule of 72, compounding periods, and discount rates.

The Rule of 72 The rule of 72 is a simple way to establish the difference that the return on an investment makes in accumulating assets. It tells us approximately how long it takes for a sum to double. It is given by the following formula:

Years to double = 72/Annual interest rate

Example 2.5 Compare how quickly money would double at (a) an 8 percent annual rate of return and (b) an 18 percent annual rate of return.

a. 8%

Years to double = 72/8 = 9 years

b. 18%

Years to double = 72/18 = 4 years

In other words, it would take more than twice as long for the 8 percent investment to double as it would for the 18 percent one. If $1,000 were deposited in the 8 percent investment, it would be worth $2,000 in about nine years, whereas by year 9 the 18 percent investment would be worth $4,435.

Compounding Periods The number of compounding periods tells you how often interest on interest is calculated. Generally, it involves the number of times that compounding occurs per year. The more often interest on interest is calculated, the higher the investment return. For example, if you were offered yearly compounding for your $1,000 deposit at an 8 percent rate for 10 years, you would have $2,159. If, in the same example, you were offered quarterly compounding, you would receive $2,208. In your calculations, assume that yearly compounding is used unless told otherwise. To obtain an approximation of the sum for more frequent compounding, divide the yearly interest rate by the number of compounding periods per year and multiply the number of years you compound by the number of compounding periods per year. Thus:

Yearly Compounding

FV = PV × 11 + i2n n = Number of years

Multiperiod Compounding

FV = PV × a1 + ipb n×p

Chapter Two The Time Value of Money 33

p = Number of compounding periods each year

FV = 1000 × a1 + .08 4 b


= 2,208

Compounding yearly:

Inputs: 10 8 –1,000

Solution: 2,159


Compounding quarterly:


Solution: 2,208

Inputs: 40 2


Discount Rate As mentioned, the discount rate is the rate at which future values are brought back to the present. Generally, it is obtained by taking the rate of return offered in the market for a comparable investment. It is sometimes called the present value interest factor (PVIF) in discounting and can be referred to by other terms, depending on the calculation being per- formed. The higher the discount rate, the lower the present value of a future sum. For a variety of reasons, discount rates may be higher or lower, which we discuss in Chapters 8 and 10. One reason is the inflation rate. Typically, the higher the rate of inflation, the higher is the discount rate. If the discount rate is 6 percent in a relatively low-inflation en- vironment such as the United States, $40,000 promised in 10 years will have a present value of $22,336. That same amount promised in a high-inflation economy such as Australia’s in the 1980s might have a discount rate of 9 percent. In such a high-inflation country, $40,000 promised in 10 years would have a present value of only $16,896. If you want to solve for the discount rate, you can do so by again moving around terms in the same formula:

11 + i2n = FV PV

Example 2.6 Susan has promised to pay Paul $40,000 in nine years if he gives her $20,000. What discount rate is Susan using?

11 + i29 = 40,000 20,000

Inputs: 9 –20,000 40,000

Solution: 8


Calculator Solution

Calculator Solution

34 Part One Planning Basics

Periods The number of compounding periods is the last variable in the formula you solve for. For example, you may be asked how long it will take for $10,000 to reach $19,672 if the rate of interest is 7 percent.

11 + i2n = FV PV

11 + .072n = 19,672 10,000

Inputs: 7 –10,000 19,672

Solution: 10



An annuity is a series of payments that are made or received. You may make a series of pay- ments to reduce and finally eliminate a loan. Alternatively, you may make an investment that entitles you to receive a stream of income over the rest of your life. In this chapter, we are concerned with ordinary annuities, which are level streams of cash flow over a period of time. All the approaches to solving the problems that we used before can be used here. The difference is that the formulas must accommodate multiple cash flows instead of a single one. Let’s do one.

Future Value of an Annuity

FVA = PMT × 11 + i2n − 1


FVA = Future value of an annuity

PMT = The annual payment made at the end of each year by the investor to the account

Example 2.7 Jack and Alice want to deposit $3,000 at the end of each year to accumulate money for a col- lege fund for their daughter, who was just born. They expect a return of 7 percent on their money. How much will they have at the end of her 17th year (see Figure 2.7)?

FVA = 3,000 × 11 + 0.07217 − 1




17 7 –3,000



Regular Annuity versus Annuity Due When annuity payments are made at the end of the period, the annuity is called an ordinary annuity or regular annuity. When payments are made at the beginning of the period, the annuity is called an annuity due. It gives you one extra year of compounding for payments

Calculator Solution

Calculator Solution

Chapter Two The Time Value of Money 35

made. For the calculator solution to have payments at the beginning of the period, set the cal- culator in the BEGIN mode (HP12C—press the keystroke g and then BEG ; TI BA II Plus— use the following sequence: 2nd BGN and 2nd SET ). To avoid mistakes, always remember to switch back to the END mode once you have finished with the BEGIN mode calculations. Unless you are told otherwise, assume that payments are made at the end of the period.

Present Value of Annuity

PVA = a n



11 + i2t PVAD = PVA × 11 + i2

= C a n



11 + i2tS × 11 + i2

PVA = Present value of an annuity

PVAD = Present value of an annuity due

©nt=1 = Sum of a series of payments starting with the present period (time period 1) and extending to time period n (generally the end of the period)

Example 2.8 Elena was offered annuity payments of $6,000 at the beginning of each year for 30 years. The discount rate was 7 percent. What should she pay (see Figure 2.8)?

PVAD = C a 30



11 + .072tS × 11 + .072

= $79,666

FIGURE 2.7 Future Value of an Annuity

0 1 2 3 16 17

–$3,000 –$3,000 –$3,000 ……


–$3,000 –$3,000

i = .07 i = .07 i = .07 i = .07



FIGURE 2.8 Present Value of an Annuity Due

$6,000 $6,000 $6,000 $6,000 ...… $6,000



Year i = .07 1 i = .07 2 3 ...... 29 30i = .07 i = .07

36 Part One Planning Basics

Set the calculator in the BEGIN mode.

Inputs: 30 7 6,000

Solution: 79,666


Example 2.9 We know all the cash inflows and outflows for our annuity streams and can solve for the rate of return. Varda was offered an annuity of $8,000 a year for the rest of her life for a payment currently of $100,000. She and the insurance company assume that she has a 20-year life expectancy. What is her anticipated return on the policy?

PVA = a n



11 + i2t

100,000 = a 20



11 + i2t

Inputs: 20 –100,000 8,000

Solution: 5


Periodic Payment for an Annuity We solve for a periodic payment to decide how much we have to pay, assuming a level payment each period. A common type of periodic payment is a loan.

Example 2.10 Fred took out a $25,000 loan, which he promised to fully retire after eight equal yearly pay- ments. The interest rate on the loan is 8 percent. When interest and principal payments are combined, how much will he pay annually?

Inputs: 8 8 25,000

Solution: –4,350


Perpetual Annuity A perpetual annuity is a stream of payments that is assumed to go on forever. One ex- ample of this type of annuity is a preferred stock. A preferred stock’s value emanates from its dividend, which is generally level and in theory is paid forever. The calculation of the present value of a preferred stock is simply the dividend divided by the appropriate interest rate.



PVAp = Present value of a peretual annuity

Example 2.11 John was considering purchasing a preferred stock paying $5 per share annually. The market interest rate for that type of stock was 9 percent. How much should he pay for the preferred?

Calculator Solution

Calculator Solution

Calculator Solution

Chapter Two The Time Value of Money 37


PVAp = 5


= $55.56


In the sections on time value of money, we performed calculations based on either lump sums or multiple payments of the same amount of money. But in many instances the pay- ments are for differing amounts. We can call these differing payments irregular cash flows. Often, the procedure for solving problems with irregular cash flows is to bring all in- flows and outflows to the beginning of the period. In essence, each cash flow will be a separate subproblem with a different number of compounding periods. The solution will be to add up all the subproblems as diagrammed in Figure 2.9. Fortunately, you can solve this problem in one step by using multiple registers of the calculator.

Example 2.12 Manny had an investment that would supply him $5,000 in year 1, $4,000 in year 2, $3,000 in year 3, and $1,000 in year 4. He wanted to know how much he should be willing to pay for that investment today if he wanted to earn 10 percent on his investment. (See Figure 2.9.)

General Calculator Approach Specific HP12C Specific TI BA II Plus

Enter initial cash outflow 0 g CF0 0 ENTER ↓

Enter cash inflow year 1 5,000 g CFi 5,000 ENTER ↓ ↓

Enter cash inflow year 2 4,000 g CFi 4,000 ENTER ↓ ↓

Enter cash inflow year 3 3,000 g CFi 3,000 ENTER ↓ ↓

Enter cash inflow year 4 1,000 g CFi 1,000 ENTER ↓ ↓

Enter the discount rate NPV

10 i 10 ENTER ↓

Calculate the net present value f NPV CPT

10,788 10,788

Calculator Solution

Clear the register CF

2nd CLR Work f FIN

i = .1 i = .1 i = .1 i = .10 1 2 3 4

$5,000 $4,000 $3,000 $1,000






YearFIGURE 2.9 Present Value of Series of Irregular Payments

38 Part One Planning Basics


Earnings is the amount received, and the earnings rate is the return on assets held. Inflation, the rate of increase in prices in our economy or in specific items, can distort earnings results. For example, you may receive $2,000 a year in dividends from stocks today. Those dividends are projected to grow 3 percent a year. Suppose that overall infla- tion, meanwhile, is expected to increase by 5 percent a year. That means the inflation- adjusted return on stocks in the form of dividends will decline each year. We call the inflation-adjusted return on assets the real return. The real return on assets contrasts with the nominal return. The nominal return and nominal dollars are the figures we are accustomed to seeing. They are based on the actual number of dollars received, not those adjusted for inflation. When the nominal number of dollars goes up but the value in real dollars goes down, those dollars can purchase fewer goods and services. As a result, we have had a decline in purchasing power terms. We can calculate the real return:

RR = a1 + r 1 + i

− 1b × 100 where

RR = Real return

r = Investment return i = Inflation rate

When multiplying by the real return to get a new cumulative sum, we use the real growth rate, which is equal to 1 + r1 + i . We will employ the real return frequently in capital needs analysis in Chapter 17.

Example 2.13 Brad was about to retire. He wanted to live on the return on the $500,000 savings he had accumulated and leave the principal amount to his children. The $500,000, which is increasing 3 percent annually, provided him $35,000 this year. Inflation is projected to rise 5 percent per year. Calculate the amount of cash he has available to spend currently as well as how much he will receive in nominal and real dollars over the next five years.

Cash availabe = $35,000 this year Nominal return year 1 = 35,000 × 11 + Nominal growth rate2

= 35,000 × 1.03 = 36,050

Real return year 1 = 35,000 × Real growth rate

= 35,000 × 11 + 0.032 11 + 0.052

= 35,000 × 0.9810 = 34,335

Years 0 1 2 3 4 5

Nominal dollars $35,000 $36,050 $37,132 $38,245 $39,393 $40,575 Real dollars 35,000 34,335 33,683 33,043 32,415 31,791

Chapter Two The Time Value of Money 39

Sample calculation for = Real dollars year 5

Real return = a1.03 1.05

− 1b × 100 = −1.9048%

Inputs: 5 –1.9048 –35,000

Solution: 31,791


Brad’s situation is deteriorating each year. That is because the growth rate of his income is 3 percent while the inflation rate is 5 percent. More precisely, as this solution shows, his re- turns are declining 1.9048 percent in real terms annually. Each year while his cash amounts in nominal dollars are going up, in real dollars, they are dropping. Consequently, his dollars will be able to purchase fewer and fewer goods over time. If he cannot raise the returns on his assets so that they are more in sync with the inflation rate, he will have to accept either a lower standard of living or a reduced amount to be left to his children, even in nominal terms.


The internal rate of return (IRR) uses time value of money principles to calculate the rate of return on an investment. IRR obtains that rate of return by combining all cash flows including cash outflows (usually initial outlays to purchase the investment plus any subsequent losses) and cash inflows (generally, the income upon the investment plus any proceeds upon the sale of the investment). The IRR is the discount rate that makes the cash inflows over time equal to the cash outflows. We discuss the IRR and a related measure, the NPV, more extensively in Chapter 8. A simple example of the IRR and the keystrokes to solve it is given in Example 2.14.

Example 2.14 Lena had a stock that she purchased for $24. She received dividends one and two years later of $0.80 and $0.96, respectively and then sold her investment in year 3 for $28. What is her IRR?

Calculator Solution

General Calculator Approach Specific HP12C Specific TI BA II Plus

Enter initial cash outflow 24 CHS g CF0 24 +/- ENTER ↓

Enter cash inflow year 1 0.80 g CFi 0.80 ENTER ↓ ↓

Enter cash inflow year 2 0.96 g CFi 0.96 ENTER ↓ ↓

Enter cash inflow year 3 28 g CFi 28 ENTER ↓ ↓

Calculate the internal rate of return f IRR IRR CPT

7.7% 7.7%

The IRR was 7.7%.

Calculator Solution Clear the register f FIN CF

2nd CLR Work


The annual percentage rate, or APR, is an adjusted interest on a loan. The Federal Truth in Lending Act mandates that this rate be disclosed on all loans so that consumers can compare the rates offered by different lenders. The APR incorporates many costs other than interest that make its rate different from the one included in a lending contract. For example, the APR on a 7 percent mortgage loan would be more than 7 percent because of such items as loan processing fees, mortgage insurance, and points.

40 Part One Planning Basics

By comparing these costs, we may find that two loans that each has a 7 percent interest rate may have different APRs of, say, 7.10 percent and 7.25 percent, respectively. Other costs in connection with that same loan, such as attorney fees, home inspection fees, and appraisal fees, are excluded from the APR. When those non-APR costs in alternative loans materially differ, they should be included in decision planning. The APR is best used to compare similar types of loans for similar periods of time. For example, if you were to compare a 15- and a 30-year mortgage, the results, given the same closing costs, would differ because those costs are spread over different periods of time, thereby distorting your comparison. Adjustable rate mortgage comparisons can be more complicated because their costs can depend in part on other factors such as the benchmark rate determining future expense.3

The benchmark figure must be used carefully, and it is a good idea to separate all costs from alternative lenders and compare them as well as noting their relative APRs. Now that you know and appreciate time value of money principles, you can use them to help make financial decisions. Because all operating parts of financial planning employ financial calculations, these principles and formulas will come in handy.

3 The benchmark is the specific market-developed rate that determines how much the borrower will pay. See adjustable rate mortgages in Chapter 7.

Back to Dan and Laura TIME VALUE OF MONEY Our next meeting was scheduled to be on cash flow planning. However, Dan and Laura e-mailed me to ask if they could have meet about some specific problems that had come up. I, of course, agreed, and, when they came into the office, I noted the stern look on Dan’s face. They had had a disagreement. Ostensibly, it was about tax payments. Laura wanted Dan to claim seven dependents on his withholding form at work because they always had received a large refund when their return was filed. That action could, of course, lead to a higher amount of deductions and therefore more available cash during the year but a po- tential tax payment on April 15. The practice doesn’t change the ultimate cash outflow but does change its timing and therefore involves time value of money. I suspected that their disagreement would not only be about tax payments and the time value of money but also about their differing beliefs about spending money. Sure enough, when I asked why she wanted to do it, Laura said so that they would get more money to spend currently. Dan couldn’t see why they would want to jeopardize their already precarious current cash position. There was the possibility of underpayment, which would result in a large disbursement when the final tax return was due. He said they could end up with even higher credit card debt to finance the tax payment if Laura spent all the cash available during the year. Laura didn’t see the problem. She said, “We aren’t paying any more to the government under this approach.” Both wanted my opinion of this practice. Dan mentioned that he had received an offer to purchase a bond for $15,000 that would pay back $50,000 in 30 years with no interest in the meantime. He thought that sounded attractive. Laura said she saw a study that said $1,000 invested in stocks 75 years ago adjusted for inflation would be worth more than 50 times that of a comparable investment in bonds. Is that true, and, if so, shouldn’t they put all of their money in stocks? They then started to criticize each other’s beliefs about the appropriate level of risk. I had often seen disagreements erupt at meetings concerned with constructing a finan- cial plan. I decided to deal with it directly, early in the planning process. It could make subsequent meetings more productive.

Chapter Two The Time Value of Money 41

I told them that emotionally charged differences of opinion sometimes took place at fi- nancial planning meetings. I believed that in part they came from the stress of having to think about long-term factors and make decisions concerning them. Of course, the funda- mental reason was the differences in personalities and beliefs. I assured them that virtually all the decisions they made could be modified or changed later. I mentioned that I found it ironic that many people selected mates who were dissimilar in certain traits from them- selves and could complement their own “weaknesses” but later came to criticize those very traits. I told them I thought that Dan’s innate conservatism offset Laura’s aggressive investment posture and that his desire to protect household finances as shown by the in- come tax withholding issue and anxious demeanor blended well with Laura’s more laid- back convenience-oriented approach. I reminded them that in my experience people seldom selected mates who were exactly like themselves. That talk seemed to ease the tension, and we moved on to the last point. Laura’s mother had been offered an annuity in which she would deposit $200,000 and receive $15,530 a year over her expected 23-year life span. Laura was already familiar with the advantages and disadvantages of an annuity, and she just wanted to know what the rate of return was and whether I considered the return attractive.

Here’s how I explained the concept of time value of money: All the questions you have raised, to varying degrees, have to do with the time value of money. The literal meaning of this term is that money given or received has a value. The value is generally what you could earn on that sum by investing it in marketable securities. Rather than further describing time value principles, I suggest you read a basic finance textbook or more simply a good manual on the use of a financial calculator. I recommend the HP12C or the TI BA II Plus. Given your desire for information on how I arrived at my financial decision and not knowing whether you already have a financial calculator, I will provide generic calcu- lator keystrokes. I’ll handle the calculations first and the question on withholding at the end. Compounding for an investment involves not only interest on an original sum but interest on interest. If we receive compound interest for an extended period of time, the interest on interest takes on increasing importance. Over longer periods, interest on interest can actually dwarf the original sum. Compounding can make it difficult to accurately assess the return on an investment without calculating it. Sometimes what looks like a great return isn’t. I believe that the proposal that Dan has is an example of something that looks like a good investment, but isn’t. Dan is being offered a zero coupon bond, which just means that all interest and principal are paid at maturity. The fact that he will more than triple his original sum over time makes it look attractive. However, we can reject this investment with a simple calculation.

Inputs: 30 –15,000 50,000

Solution: 4.1


That rate of return of 4.1 percent compares with U.S. government bonds for that same period of 5 percent. We don’t even have to incorporate risk (the bond being offered is of a medium-quality business) or take into account the negative tax consequences of this type of bond in a nonpension account. This bond is not attractive. The example Laura presented is an illustration of how compounding can make a huge difference in returns over time. The returns she expressed were over a 75-year period. They were adjusted for inflation. I will assume 11 percent per year for stocks, 5.5 percent per year for bonds, and 3 percent for inflation.

42 Part One Planning Basics

The real return for stocks and bonds is the return after adjusting for the negative effect of inflation. It is given by the following formula:

Real return = a1 + r 1 + i

− 1b × 100

For stocks:

Real return = a1.11 1.03

− 1b × 100 = 7.77

Inputs: 75 7.77 –1,000

Solution: 273,171


Compounding $1,000 for 75 years at the real return for stocks is $273,171. Similarly, cal- culating the real interest rate and compounding for bonds yields $4,230.

Real return 1bonds2 = a1.05 1.03

− 1b × 100 = 1.9417

Inputs: 75 1.9417 –1,000

Solution: 4,230


As can be seen, it is true that alternate compounding rates can make an enormous differ- ence and that the stocks increased more than 50 times than bonds did. Whether stocks or bonds or, more likely, a combination of the two is appropriate for you will be left to our discussions on investments. Your mother’s rate of return on her annuity can be calculated as follows:

Inputs: 23 –200,000 15,530

Solution: 5.5


The 5.5 percent return on investment offered does not seem attractive relative to the 5 percent return on U.S. government bonds. The government bond will repay principal at the end of 23 years, but the annuity does not provide any principal, only interest payments. Your mother should either seek another estimate or place her money in something else. Finally, you have a difference of opinion on how to handle tax withholding. For Laura, as indicated in this write-up, money over time has worth. The money you give to the IRS early could be invested in a money market fund or some other investment that would provide you some income. So Laura is correct that from a financial standpoint, overwithholding is inefficient. Yet many people overwithhold. They may do this to avoid an abrupt payment on tax day, April 15. Alternatively, they may use overwithholding so that they can receive what they feel is an unexpected bonus from Uncle Sam that they can then spend. These are

Chapter Two The Time Value of Money 43

nonfinancial human reasons. I have explained the advantages and disadvantages as I see them. Whether you want the financial sacrifice for the sake of the comfort and structure provided by overwithholding is up to you. Let me end with a personal note that may not be part of many financial planners’ writ- ten documents but that you have asked me to include whenever I thought it useful. Money matters, like many others in life, can result in differences of opinion. Given my earlier re- marks to you, you have an idea of how I feel. Basically, you can run your monies sepa- rately with differences in assets selected, tax withholding rules, and a host of other decisions. Or, as most couples do, at least for first marriages, you can compromise so that both people make meaningful sacrifices. You should both verbalize your differences and try to reach a settlement of the issues and go forward together in financial matters. If you would like my input on any specific financial problem, please let me know.

Summary The time value of money is one of the basic ideas in finance. As such, it is very important that you understand how to use it in decision making.

• The time value of money enables you to make correct decisions when current or future amounts need to be established or when deciding which alternative is best. It allows impartial comparison of past or future performance or values.

• Cumulative sums are highly sensitive to the number of compounding periods and to the rate of return used. For example, using the rule of 72, it will take 12 years for a sum to double in value when the rate of return is 6 percent but only 4 years when the rate is 18 percent.

• It is essential when making decisions to know the present value, the future value, the discount rate for lump sums and for annuities.

• Real rates of return are those adjusted for inflation. This chapter gives an exact formula that can be approximated by subtracting the inflation rate from the indicated return.

• The internal rate of return (IRR) is the one most commonly used to compare the return on investments that have differing inflows and outflows over time.

Key Terms annual percentage rate (APR), 39 annuities, 34 annuity due, 34 compounding, 27 discount rate, 33

future value, 31 inflation, 38 internal rate of return (IRR), 39 irregular cash flows, 37 nominal return, 38

ordinary annuity, 34 perpetual annuity, 36 present value, 29 real return, 38 time value of money, 26

teachmefinance.com Time Value of Money This website covers concepts such as the time value of money, future values of un- even cash flows, annuities, perpetuities, techniques involving cost of capital calcula- tions, cost of capital budgeting, and a host of other things.


Questions 1. What is compounding, and why is it important? 2. Why is knowledge of the time value of money useful?

3. Explain the terms PV and FV.

4. What rate is most often used for time value of money calculations?

44 Part One Planning Basics

5. If the discount rate on a proposed investment is raised, what happens to its present value? Why?

6. Would a lump sum today or the comparable amount in periodic payments deposited over time provide a higher FV? Why?

7. Explain regular annuity versus annuity due and give examples.

8. What is rate of return and why do we use inflation-adjusted return?

9. What are the differentiating factors between regular annuity and annuity due?

10. How is the Rule of 72 a helpful tool?

11. What is future value and how is it calculated?

12. What would be the consequence of not accounting for inflation?

13. What is the significance of IRR?

Problems 2.1 What is the present value of a $20,000 sum to be given six years from now if the discount rate is 8 percent?

2.2 What is the future value of an investment of $18,000 that will earn interest at 6 percent and fall due in seven years?

2.3 Jason was promised $48,000 in 10 years if he would deposit $14,000 today. What would his compounded annual return be?

2.4 How many years would it take for a dollar to triple in value if it earns a 6 percent rate of return?

2.5 Marcy placed $3,000 each year into an investment returning 9 percent a year for her daugh- ter’s college education. She started when her daughter was two. How much had she accu- mulated by her daughter’s 18th birthday?

2.6 Todd was asked what he would pay for an investment that offered $1,500 a year for the next 40 years. He required an 11 percent return to make that investment. What should he bid?

2.7 Ann was offered an annuity of $20,000 a year for the rest of her life. She was 55 at the time, and her life expectancy was 84. The investment would cost her $180,000. What would the return on her investment be?

2.8 How many years would it take for $2,000 in savings a year earning interest at 6 percent to amount to $60,000?

2.9 Aaron has $50,000 in debt outstanding with interest payable at 12 percent annually. If Aaron intends to pay off the loan through four years of interest and principal payment, how much should he pay annually?

2.10 What is the difference in amount accumulated for a $10,000 sum with 12 percent interest compounded annually versus one compounded monthly over a one-year period?

2.11 What is the difference in future value between savings in which $3,000 is deposited each year at the beginning of the period and the same amount deposited at the end of the period? Assume an interest rate of 8 percent and that both are due at the end of 19 years.

2.12 Kenneth made a $20,000 investment in year 1, received a $5,000 return in year 2, made an $8,000 cash payment in year 3, and received his $20,000 back in year 4. If his required rate of return is 8 percent, what was the net present value of his investment?

2.13 John had $50,000 in salary this year. If this salary is increasing 4 percent annually and in- flation is projected to rise 3 percent per year, calculate the amount of return he will receive in nominal and real dollars in the fifth year.

2.14 Becky made a $30,000 investment in year 1, received a $10,000 return in year 2, $8,000 in year 3, $11,000 in year 4, and $9,000 in year 5. What was her internal rate of return over the five-year period?

Chapter Two The Time Value of Money 45

Case Application TIME VALUE OF MONEY Richard e-mailed me that he and Monica differed about the impact of his extra spending over the past 15 years. He calculated it at about $3,000 a year. He said the total cost of $45,000 was well within his capability to make up. Monica said the cost was much higher and asked that they compute it. They had been offered an investment of $20,000 that would pay $70,000 in 20 years. They want to know if they should take it. Finally, Richard could sign up for an annuity at work. It would cost $100,000 at age 65 and provide payments of $8,000 per year over his expected 17-year life span. He wants to know if it is attractive. The appropriate market rate of return on investments is 7 percent after tax.

Case Application Questions 1. Calculate what the $3,000-per-year deficit, had it been invested, would have amounted

to at the end of the 15-year period.

2. Explain to Richard what compounding is and how it affected the cumulative amount received in question 1.

3. Calculate the return on the proposed $20,000 investment and indicate the factors enter- ing into your recommendation to accept or reject it.

4. Indicate the expected return on the annuity and whether it should be accepted or rejected.

5. Explain the time value of money for the financial plan using your answers to questions 1 through 4 in this part of the financial plan to help you communicate the time value information to Richard and Monica.

Appendix I

Serial Payments Serial payments are payments received or given that increase by a constant percentage each year. The constant percentage is often linked to the inflation rate with other potential figures including the rate of growth in a financial investment or in salary. Savings is a good example of how to use serial payments effectively. As you will see in the following example, devel- oping a required sum over an extended period by saving a constant amount each year may not be practical. That is because salaries go up over time, making it more practical to save an increasing amount as we continue to work. Serial payments can also handle such a situation. Another example is an increasing annuity. The amount we receive as an annuity may increase at a constant percentage. For example, a disability policy may provide a 5 percent increase in payout each year beginning when a person becomes disabled. The intention there is to cushion the effect of inflation. Here is the formula for serial payments:


1. Calculate the real return. Use the formula given earlier:

RR = a1 + r 1 + i

− 1b × 100 Percentage value should be converted to decimal value.

46 Part One Planning Basics

2. Develop the base first-year payment.

a. First find the cumulative real return, which is the sum of all years’ real returns. The real return of one particular year is the sum of 1 plus the real return calculated in step 1, and this sum is raised to the power of the number of periods to conclusion of the serial payment.

Mathematically, it is

CRR = 11 + RR2n + 11 + RR2n−1 + 11 + RR2n−2 + p + 11 + RR2n−n where

CRR = Cumulative real return RR = Real return in decimal value n = Number of periods to conclusion

b. Divide the desired ending value expressed in current dollars by the calculated CRR to obtain the base first-year payment (FYP).


CRR where

CST = Cumulative sum in today’s dollars FYPb = First-year payment beginning of year

3. Multiply the first-year payment by 1 plus the inflation rate for each year beyond the first.

YP = FYP × 11 + i2n

4. If the amount required is to be paid at the end of the year, multiply each payment by 1 plus the inflation rate.

YPe = YPb × 11 + i2 where

YPe = Yearly payment at end of year

Example 2.A1.1 Dan wanted to save $50,000 in today’s dollars as a down payment on a house in four years. His income was increasing, which would make it possible for him to save higher and higher amounts as he came closer to the down payment date. He decided to increase his yearly sav- ings by the rate of inflation. He wanted to know how much he would have to save each year to reach his goal, assuming that inflation was 3 percent, his investment return was 5 percent, and payments would be made at the end of each year.

RR = a1.05 1.03

− 1b × 100 = 1.9417 1percentage value2

RR = 0.019417 1decimal value2 1 + RR = 1 + 0.019417 = 1.019417

CRR = 11.0194172 14−12 + 11.0194172 14−22 + 11.0194172 14−32 + 11.0194172 14−42 CRR = 11.01941723 + 11.01941722 + 11.01941721 + 11.01941720

= 4.1180

Chapter Two The Time Value of Money 47

FYPb = 50,000


= $12,141.82 at the beginning of year

FYPe = 12141.82 × 11.032 = $12,506.07 at the end of year

Successive payments rising by the rate of inflation multiplied by 1.03 were $12,881.25, $13,267.68, and $13,665.72.

1 $12,506 3 $1,971 $51,500 2 12,881 2 1,320 53,045 3 13,268 1 663 54,636 4 13,666 0 0 56,276

$52,321 $3,955 $56,276

Year Required Total


Number of Compounding


Returns on Payment at 5 Percent

Required Down Payment Sum

Appendix II

Excel Examples* We have already discussed how you can solve financial problems using a financial calcula- tor. In this appendix, you will learn how to use Excel to solve the problems presented throughout the chapter.

ANNUAL COMPOUNDING We will calculate the principal resulting after one period and two periods of compounding. Notice the difference when we compound for more than one period. (See Figure 2.A2.1.)

Building This Model in Excel

1. Inputs. Enter the input data in the ranges B6:B8 and B15:B17. 2. Compounding. Use the formula for annual compounding to calculate the principal at

the end of the compounding periods:

Principal end of compounding period = Principal × 11 + Inerest rate2Number of years

* Troy A. Adair, Excel Applications for Corporate Finance (Burr Ridge. IL: McGraw-Hill/Irwin, 2005), and Craig Holden, Excel Modeling in Investments, 2nd ed. (New Jersey: Prentice Hall, 2005).

Note that the required sum at the end of the period is $56,276, not $50,000 because inflation has increased the required sum. In other words, $56,276 is $50,000 in real (inflation- adjusted) terms at the end of four years. When added, the required payments are also higher than $50,000 and would have been even higher if not for the investment return on the first three years’ deposits. When the required payments are combined with interest on those payments, they add to the required down payment sum.

48 Part One Planning Basics

• One-period compounding. Enter B6*(1 B7) in cell B9. This is a one-year period, so don’t put a power to the expression in the parentheses because it is 1.

• Two-period compounding. Enter B14*(1 B15)^2 in cell B17. This time you use the power of 2 for the two-year period.

PRESENT VALUE We will calculate the present value of a single cash flow in two ways: using the formula for present value of a single cash flow and using the built-in Excel function PV.

Example 2.A2.1 What is the present value of $223,073 to be received 50 years from now if the interest rate is 9 percent? (See Figure 2.A2.2.)

Building This Model in Excel

1. Inputs. Enter the input data in the range B4:B6. 2. Present value using the formula. Enter B4/(1 B5)^B6 in cell B9. Use the following

formula to calculate the present value of a single cash flow:

Present value = Cash flow/ 11 + Discount Rate2Number of periods 3. Present value using the Excel PV function. The Excel PV function has five


PV1rate, nper, pmt, fv, type2 The first parameter rate is the discount rate per period (year, month, day, etc.), nper is the number of periods, and fv is the future value of the cash flow; pmt and type are used to handle annuities, which we discuss later. In this case, put 0 for pmt and nothing for type, which Excel takes as 0. The type parameter has two values—0 and 1—which indi- cate whether the cash flow occurs at the end (0) or at the beginning (1) of the period. The Excel PV function can be used to calculate the present value of a single cash flow, the present value of an annuity, and the present value of a bond price. We put a negative

FIGURE 2.A2.1 Excel Model for One- Period versus Two- Period Compounding

1 2 3 4 5 6 7 8 9 10 1 1 12 13

14 15 16 17 18 19

A B C D E Annual Compounding

One-Period Compounding

Inputs Principal beginning of year $2,000 Interest rate 10% Number of years 1

Principal end of year 1 $2,200

Two-Period Compounding

Inputs Principal beginning of year $2,000 Interest rate 10% Number of years 2

Principal end of year 2 $2,420



Chapter Two The Time Value of Money 49

sign in front of the PV function because otherwise it returns a negative result. Again, this is somewhat irritating, but it is the way to handle that problem.

Enter = −PV(B5,B6,0,B4) in cell B12. Notice that we get the same result ($3,000) both ways.

FUTURE VALUE We will calculate the future value of a single cash flow in two ways: using the formula for the future value of a single cash flow and using the built-in Excel function FV.

Example 2.A2.2 If you were to deposit $7,000 in a certificate of deposit for six years earning 5 percent annually, how much would you have accumulated at the end of the period? (See Figure 2.A2.3.)

Building This Model in Excel

1. Inputs. Enter the input data in the range B4:B6. 2. Future value using the formula. Enter B4*(1 B5)^B6 in cell B9. Use the following

formula for calculating the future value of a single cash flow:

Future value = Cash flow × 11 + Interest rate2Number of periods 3. Future value using the Excel FV function. The Excel FV function has the same for-

mat and parameters as the PV function except for the fourth parameter, which is pv:

FV1rate, nper, pmt, pv, type2 The built-in FV function can be used to calculate the future value of a single cash flow,

the future value of an annuity, and the future value of a bond price. Again, put a nega- tive sign in front of the FV function so that the future value result will be positive. Enter FV(B5,B6,0,B4) in cell B12.

Notice that again that the result ($9,381) is the same using both methods.

SOLVING FOR THE DISCOUNT RATE Some problems have to be solved for the discount rate. There is no closed-form solution for that particular problem, but Excel makes the work easier by offering a built-in function that will solve for the discount rate. The function Rate has the following format and parameters:

Rate1 nper, pmt, pv, fv, type, guess2

FIGURE 2.A2.2 Excel Model for Present Value of a Single Cash Flow

1 2 3 4 5 6 7 8


10 1 1




Present Value of a Single Cash Flow

Inputs Future cash flow $223,073 Discount rate 9% Number of years 50

Present Value Using the Formula

Present value $3,000

Present Value Using the Excel PV Function Present value $3,000


= –PV(B5,B6,0,B4)

50 Part One Planning Basics

All the parameters were defined earlier except for guess, which refers to your optional first guess at the correct answer. Generally, you can omit it.

Example 2.A2.3 Susan has promised to pay Paul $40,000 in nine years if he gives her $20,000 now. What dis- count rate is Susan using? (See Figure 2.A2.4.)

Building This Model in Excel

1. Inputs. Enter the input data in the range B4:B6. 2. Discount rate using the Excel Rate function. Enter Rate(B6,0,B4,B5) in cell B9. Put

0 for the second parameter, pmt, because it is used for annuities. The trick here is that the function works only when the present value and future value have opposite signs. This is the reason for putting a negative sign in front of the present value. Although ir- ritating, this step is necessary to get the proper result.

SOLVING FOR THE NUMBER OF COMPOUNDING PERIODS Sometimes problems have to be solved for the number of compounding periods. That par- ticular problem has no closed-form solution. However, Excel makes the calculation easier because Excel has a built-in function that solves for the number of periods. This function, nper, has the following format and parameters:

Nper1 rate, pmt, pv, fv, type2 You already know the definition of all the parameters.

FIGURE 2.A2.3 Excel Model for Future Value of a Single Cash Flow

1 2 3 4 5 6 7 8


10 1 1




Future Value of a Single Cash Flow

Inputs Amount deposited $7,000 Interest rate 5% Number of years 6

Future Value Using the Formula

Future value $9,381

Future Value Using the Excel FV Function Future value $9,381


= –FV(B5,B6,0,B4)

FIGURE 2.A2.4 Excel Model for Solving for the Discount Rate

1 2 3 4 5 6 7 8



A B C D E Solving for the Discount Rate

Inputs Present value of a cash flow $20,000 Future value of a cash flow $40,000 Number of years 9

Discount Rate Using the Excel Rate Function

Discount rate 8% =RATE(B6,0,–B4,B5)

Chapter Two The Time Value of Money 51

Example 2.A2.4 How long will it take for $10,000 to reach $19,672 if the rate of interest is 7 percent? (See Figure 2.A2.5.)

Building This Model in Excel

1. Inputs. Enter the input data in the range B4:B6. 2. Number of periods using the Excel nper function. Enter nper(B6,0,B4,B5) in cell B9.

Again, use a negative sign for the present value in order to get the proper result.

FUTURE VALUE OF AN ANNUITY We can calculate the future value of an annuity in two ways: using the formula for the fu- ture value of an annuity and using the built-in Excel function FV.

Example 2.A2.5 Jack and Alice want to deposit $3,000 at the end of each year to accumulate money for a col- lege fund for their newborn daughter. They expect a return of 7 percent on their money. How much will they have at the end of the 17th year? (See Figure 2.A2.6.)

Building This Model in Excel

1. Inputs. Enter the input data in the range B4:B6. 2. Future value of an annuity using the formula. Use the following formula for calcu-

lating the future value of an annuity:

Future value = Payment 1 1 11 × DR2NP − 12/DR2 where

DR = Discount rate NP = Number of periods Enter =B4*(((1 B5)^B6 1)/B5) in cell B9.

3. Future value of an annuity using the Excel FV function. Except for future value of a single cash flow, the Excel FV function can be used to calculate the future value of an annuity. The format of the function in this case is

FV1rate, nper, pmt, 02 Put 0 for the fourth parameter because there is no cash flow at the beginning of the pe- riod; hence, the present value is 0. Put a negative sign in front of the FV function so that the future value result will be positive.

Enter =FV1B5,B6,B4,02 in cell B12. Notice that the result ($92,521) is the same both ways.

FIGURE 2.A2.5 Excel Model for Solving for the Number of Compounding Periods

1 2 3 4 5 6 7 8 9



Solving for the Number of Periods

Inputs Present value of a cash flow $10,000 Future value of a cash flow $19,672 Interest rate 7%

Discount Rate Using the Excel Nper Function Number of years 10


52 Part One Planning Basics

PRESENT VALUE OF AN ANNUITY We will calculate the present value of an annuity in two ways: using the formula for the present value of an annuity and using the built-in Excel function PV.

Example 2.A2.6 Maria was offered annuity payments of $6,000 at the beginning of each year for 30 years. The discount rate was 7 percent. What should she pay now? (See Figure 2.A2.7.)

Building This Model in Excel

1. Inputs. Enter the input data in the range B4:B6. 2. Present value of an annuity using the formula. Use the following formula for calcu-

lating the present value of an annuity:

Present value = Payment × 1 11 − 11 DR2−NP2/DR2 × 11 + DR2 Add the last part (1 + DR) because payments are made at the beginning of each year. In this case, there is an annuity due. Basically, the formula for the present value of a regu- lar annuity is

Present value = Payment × 1 11 − 11 DR2−NP2/DR2 Enter = B4*((1 (1 B5)^( B6))/B5)*(1 B5) in cell B9.

FIGURE 2.A2.6 Excel Model for Future Value of an Annuity

1 2 3 4 5 6 7 8


10 11




Future Value of an Annuity

Inputs Payment $3,000 Discount rate 7% Number of years 17

Future Value Using the Formula Future value $92,521

Future Value Using the Excel FV Function Future value $92,521


= –FV(B5,B6,B4,0)

FIGURE 2.A2.7 Excel Model for Present Value of an Annuity

1 2 3 4 5 6 7 8


10 1 1




Present Value of an Annuity

Inputs Payment $6,000 Discount rate 7% Number of years 30

Present Value Using the Formula Present value $79,666

Present Value Using the Excel PV Function Present value $79,666


= –PV(B5,B6,B4,0,1)

Chapter Two The Time Value of Money 53

3. Present value of an annuity using the Excel PV function. Except for the present value of a single cash flow, the Excel PV function can be used to calculate the present value of an annuity. The format of the function in this case is

PV1rate, nper, pmt,0, 12 The format of this function is similar to the format of the function for the future value of an annuity except for the fifth parameter. If you recall, the PV and FV functions have five parameters, the last of which is type. In this case, set the type parameter to 1 because payments are made at the beginning of each year. If this is a regular annu- ity with payments made at the end of the period, put nothing for type, which Excel takes as 0.

NONANNUAL COMPOUNDING We discussed the annual compounding at the beginning of this appendix. Now we focus on nonannual compounding. We know that investments pay cash flows not only annually but also semiannually, quarterly, monthly, daily, and so on. Nonannual com- pounding deals with periods shorter than a year. As you will see, Excel can handle the nonannual compounding.

Example 2.A2.7 What is the future value of $1,000 if the annual interest rate is 8 percent and the frequency of compounding varies: annual, semiannual, quarterly, bimonthly, monthly, biweekly, weekly, and daily? (See Figure 2.A2.8.) Using the results obtained, build a graph that shows how the future value of an investment increases as frequency of compounding increases (see Figure 2.A2.9).

Building This Model in Excel

1. Inputs. Enter the input data in the range B4:B5. 2. Future value of the investment for various compounding periods. First construct the

table, filling out the data for frequency and corresponding number of periods per year.

FIGURE 2.A2.8 Excel Model for Comparing Various Nonannual Compounding Periods

1 2 3 4 5 6 7 8 9 10 1 1 12 13 14 15 16 17


Inputs Present value $1,000 Annual rate 8%

Comparison of Various Nonannual Compounding Periods

Frequency Periods per Year FV Annual 1 $1,080.00 Semiannual 2 $1,081.60 Quarterly 4 $1,082.43 Bimonthly 6 $1,082.71 Monthly 12 $1,083.00 Biweekly 26 $1,083.15 Weekly 52 $1,083.22 Daily 365 $1,083.28

= –FV($B$5/B10,B10,0,$B$4)

Nonannual Compounding

54 Part One Planning Basics

Then calculate the future values of the investment for various period lengths in the range C10:C17. Recall the formula for nonannual compounding:

Future value = Present Value × 11 + 1DR/m2 2N×m


N = Number of years m = Number of periods per year

Using this formula, make the necessary changes in the parameters of the FV function. The interest rate is divided by the number of periods per year.

Enter = –FV($B$5/B10,B10,0,$B$4) in cell C10 and copy it down to cell C17.

Note that the more frequent the compounding, the higher the future value.

FIGURE 2.A2.9 FV as Compounding Frequency Increases








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Chapter Goals

This chapter will enable you to:

• Start the financial planning process smoothly.

• Determine how human behavior influences the personal financial planning (PFP) process.

• More easily ascertain personal goals that people have.

• Employ the data-gathering process in common planning situations.

• Improve your communication skills.

• Develop desirable interviewing and counseling techniques.

This meeting with Dan and Laura was set up to further discuss personal goals that both seemed anxious about and to go over the data-gathering questionnaire they had filled out. Dan, who liked the way I handled our first meeting, asked if I would give him some tips on successful communication and interviewing techniques. He was having difficulty establish- ing rapport with an important new client.

Real-Life Planning

Albert walked in with his mother. He wasn’t the advisor’s typical client. A tall, thin boy dressed in hip-hop jeans and a T-shirt, Albert looked like a teenager. The expression on his face said, “What am I doing here?” The advisor wondered how he was going to communi- cate with this person, given their differences in age, interest, and culture. The advisor introduced himself to both Albert and his mother, made eye contact with the boy, and smiled. He offered soda and chocolate chip cookies, which had been placed at the center of the table. He had chosen his office, which had a small round table instead of the large one in the conference room that had the advisor at the head because he thought it would be more personal and friendly. The advisor was familiar with many of the facts that Albert’s mother had discussed with him over the phone. The boy had been in the back seat of a car whose driver was drunk, and the car had crashed into another one coming from the opposite direction. The boy had sustained injuries to his brain and nervous system. The injuries were not apparent but could possibly limit his functioning and therefore his job opportunities in the future. The legal settlement had come to $400,000 net of lawyer’s fees. Albert’s mother had placed the money in a bank account two years ago. Now Albert was almost 18, the age at which he would have full control over the proceeds. His mother had encouraged him to seek assistance.

Chapter Three

Beginning the Planning Process

56 Part One Planning Basics

A glance at Albert told the advisor a great deal. His arms were folded, he leaned side- ways far back in his chair, and he spoke softly without feeling. To the advisor, it meant that he was uncomfortable being there. His mother was about to say something when one glance from Albert resulted in her complete silence for the rest of the session. The advisor tried to break the ice by asking what Albert’s interests were. He said, “Having fun.” When asked what things provided him with fun, he said hanging around with friends and driving “cool” cars. It was clear that he was beginning to relax. They started to talk about his future. He wanted to join the Army and develop a trade. The advisor decided not to bring up the difficulty his injury might pose in being accepted. He began to see another side to Albert that was more mature and interested in his own well-being. The advi- sor explained how the income on the invested sum, if handled properly, could supplement his job-related cash and raise his standard of living. The advisor told him the investment income also would be available if he became seriously ill. Albert nodded slightly. The advisor decided further questioning would add little and could alienate the boy. Life insurance was out of the question, tax planning was not a serious concern outside of investments, cash flow planning would be taken care of because he lives with his mother for the time being, and retirement and estate planning would seem like it came from another planet. Besides, the advisor was being retained for investment advice. The advisor simply asked what Albert would like to do now that the money would be available. He said he would like to have a huge party that would go on for 24 hours. The next question was how much Albert thought the party would cost. He said $7,000. The advisor asked, “Is that all?” Albert replied that he would like a new red BMW convertible. The advisor asked what model and the cost. His face broke out in a smile as he mentioned the model and the cost—$60,000. The advisor mentioned that he could see how both items could be a lot of fun. Looking at it from the boy’s point of view, the advisor asked whether, if the amount were given to him, Albert would be amenable to having the balance of the money set aside for his finan- cial future. He nodded, and the advisor went over his plan for diversifying his investments according to Albert’s tolerance for risk. The next day, $67,000 was wired into a checking account and the balance to an investment account at a financial institution. The advisor thought about the reasons for what he considered a successful outcome. He decided it was because he had listened to Albert’s expressed feelings, attempted to be non- judgmental about Albert’s preferences, and looked at the situation from the boy’s perspec- tive. The advisor was able to establish himself as an authority on related matters and develop a rapport with Albert. Summing it up, he was able to communicate with Albert.


The first step in the financial planning process is to identify household goals and needs. This is usually accomplished through data gathering. It is important that proper communi- cation and interview techniques take place at that time to ensure a firm beginning to the work to be done. This chapter deals with establishing such goals, data gathering, and the communication techniques that bring about sound planning. It details the role behavioral finance and personality differences play in the process.


Finance is typically viewed as a highly structured discipline. People are taught the one “right” way to perform financial operations. Generally, the idea is to make logical decisions with the goal of receiving the highest amount of money possible. This approach can be characterized as the “ideal” person performing as a machine producing the maximum cash flow.

Chapter Three Beginning the Planning Process 57

In reality, of course, people do not act like machines. They act like human beings. They have many shortcomings and differ from each other in many respects, including prefer- ences. Behavioral finance can be defined as the concentration on actual human actions in financial matters. For an example of behavioral finance, look no further than the activities of stock market investors. Research had shown that investors are far more likely to take gains when a stock has increased in price than they are to take losses when a stock’s price has declined.1 When people sell a stock at a gain, they have succeeded, even if it might mean paying a tax. On the other hand, selling a stock at a loss is an admission of failure—of bad judgment— so many investors hold on, hoping for a recovery that will justify their earlier decision. Selling at a loss can provide a tax benefit, but some people hold on to a declining stock sometimes until it becomes literally worthless hoping it will come back. Understanding such compo- nents of people’s behavior can help in developing a reasonable personal financial plan that actually will be put into action. Indeed, behavioral financial planning notes emotional as well as financial consider- ations. This discipline strives to understand and improve people’s decision-making abili- ties so that they can more easily achieve the goals they set. For example, for the strategy regarding holding stock you have a loss indefinitely until the loss is hopefully wiped out is not a rational strategy, it does not assess the chances and time frame for the rise of the stock. Not practicing such an approach can lead to improved performance, the goal of be- havioral financial planning. Behavioral finance and behavioral financial planning are dis- cussed more fully in Chapter 18. So, as we can see, personal financial planning (PFP) is a very practical activity. It must requires analyze analyzing how people actually act to help them come closer to how to make decisions should be made. Knowledge of people’s behavior patterns and how they influence PFP are required parts of curriculua such as those that prepare individuals for the CFP® exam. PFP must take into account a variety of differences among people. In the next section, we examine some of these behavioral differences.

Cultural Background To some extent, our actions are influenced by our culture, the social, ethnic, and religious backgrounds that contribute to our beliefs, material possessions, values, and goals. Peer groups—groups of friends and associates with similar backgrounds—are those people against whom we measure ourselves. Together, culture helps create the personal- ity characteristics and attitudes that determine the lifestyle that we have established for ourselves. For example, one peer group may stress outward signs of achievement, such as material possessions, while another may emphasize balanced living or intellectual self-realization.

The Life Cycle Age is also a strong influence on our interests and preferences, as we can see by consider- ing the life cycle in terms of age categories. Three are proposed here. The age range for each category described can vary, depending on age at marriage and having children, time of retirement, and type of lifestyle. Thus, the ranges given here are somewhat arbitrary. Longer life expectancy, improved health, and increased options have all created changes in self-perception and this, in turn, affects both preferences and interests.2

1 The approach taken is one for traditional couples. Clearly, people who remain single, who choose not to have children, or who otherwise differ will have an alternative pattern. Meir Statman, “The Mistakes We Make— And Why We Make Them,” Wall Street Journal, August 24, 2009, wsj.com/news/articles/SB100014240529702 04313604574326223160094150. Statman is professor of finance at Santa Clara (California) University. 2 Life cycle planning is presented more specifically by age and topic in relevant chapters of the book.

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Young: 18–42 For the young, planning often takes a back seat, at least until they establish lasting personal relationships. Young people tend to place great emphasis on their current standard of liv- ing and fairly often on their career advancement. Thus, savings is sometimes given lower priority. Risk tolerances often can be high. When these people marry and have children, the major concern is the accumulation of real assets for a home and its possessions and life insurance to protect other household members. Borrowing to purchase these assets, and sometimes to finance graduate education, is fairly common.

Middle Aged: 43–67 For many people, the onset of middle age is an occasion for increased planning, particu- larly in regard to saving for retirement. With middle age may come better-defined parameters for careers and a more consistent cost of living because the home and its pos- sessions and the car may have already been improved. Financial assets are accumulated and expended for children’s educations and increased sums saved for retirement. Debt as a percentage of assets generally declines for two reasons: Debt on the home is being paid off and real and financial assets have increased, so the debt percentage goes down even if total debt had remained stable. In middle age, risk taking tends to decline. For some, the use of whole life insurance now replaces cheaper term life insurance. Once people have funded their children’s college obligations, their annual savings often increase markedly. They also begin to think more seriously about estate planning.

Seniors: 68 and Beyond It is a mark of change in our society that the term senior has replaced old to describe people in this age bracket. Often, seniors go through a period of active retirement, perhaps maintaining some part-time job, followed by a slower pace. Accumulation of wealth during youth and middle age gives way to spending down assets. Risk tolerance declines sharply and so does the use of debt. Taking care of others through estate planning is given a high priority. Tax rates may decline and help contribute to a decline in the cost of living when uninsurable medical and elder-care costs are not excessive.

Family Your family background can have a strong pull on how you establish your lifestyle. Those who have had a happy childhood and a strong family bond may continue the patterns set by their parents. Others who have not had them may move in the opposite direction. Some people believe that birth order is another influential factor with the eldest child more likely to be conservative, following the parents’ point of view, and the younger children more likely to become more creative and rebellious.3

Personality Your personality is the sum total of all the attributes—emotional, mental, and so on—that distinguishes you from other people. PFP views personality narrowly because our innate traits have formed or are currently being “built.”4 For example, given the same trying event, one person may be highly emotional, another more analytical; one more confident, another more anxious; one more independent, another more dependent.

3 Joshua K. Hartshorne, Nancy Salem-Hartshorne, and Timothy S. Hartshorne, “Birth Order Effects in the Formation of Long-Term Relationships,” Journal of Individual Psychology 65, no. 2 (2009), joshuakhartshorne.org/papers/BirthOrder.pdf. 4 A broader definition would include environmental factors as well.

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Our personality affects our tolerance for risk, which influences our planning actions. It and other factors help create our values, which determine our goals. Financial planning based on differing goals is discussed in Chapter 18. Finally, behavioral finance covers human weaknesses. One of the most fundamental weakness is a lack of knowledge of a subject, a common problem in financial planning. Ways to meet these weaknesses are developed in Chapter 18. In sum, the characteristics we have listed are covered under a broader definition of behavioral finance, one that goes beyond a focus solely on emotions. These characteristics are important in both understanding ourselves and assessing others. Some characteristics may contribute to shortcomings that we will want to overcome to reach our financial goals. Other characteristics may cause us to have goals that are different from a singular empha- sis on monetary achievement. Before we deal with goals and data gathering, we should understand the importance of communication in relating to others professionally and to other household members and in understanding ourselves.


Communication is very important in any activity we undertake in life. Often being honest, knowledgeable, and concerned is not good enough for all situations. We must be able to have others believe that we possess the required traits so that we can be successful in the task we have set for ourselves or the relationship we wish to establish. Communication can be defined as the ability to transmit a message successfully to another person. That success is indicated by having someone receive and understand your message in the manner you intended it to be conveyed. Communication is more complex than you may think initially. Verbal communication is a way of transmitting your thoughts and emotions through the spoken word. When you speak, you communicate in many ways. One way is through the content of the message. We can call that content the verbal message, which often contains specific information. It also can convey a message that extends beyond the specific information. For example, the tone of voice and intensity as well as the passion with which you speak also convey information, but that information is nonverbal. Through nonverbal communication you transmit your thoughts and emotions with- out or in addition to the words you use. Whether intentionally or unintentionally, your fa- cial expressions, body movements, hand gestures, use of eye contact—even the way you dress or the appearance of your office—can transmit a message. For example, through your body language, you may communicate an entirely different message than the one you’re speaking about. Thus, folding your arms across your chest and other tight gestures and facial expressions may convey a lack of receptivity even though you nod your head in agreement. This is illustrated in Figure 3.1. A movement of your body toward the speaker in a relaxed manner may signify interest in or assent to the idea being discussed whereas a shift back in your seat away from the speaker with loss of eye contact could indicate the opposite reaction. The rise in tone in your voice often conveys a strong feeling about a subject. In contrast, a weak vocal response could signify a lack of interest in or conviction about what is being discussed. As is shown in Figure 3.1, a person who expresses agreement with a message in a free, animated way with eyes focused on the other person is clearly more likely to receive, pro- cess correctly, and agree with the content of that message. There are many reasons for communicating with another person. You may want to express your opinion or feelings about a matter. You may wish to convey some specific facts or to persuade someone to hire you or to follow your advice. In some instances, your

60 Part One Planning Basics

goal is not to communicate a message but to develop a relationship with another person. If you are acting as an advisor, your intent can fall into any of those categories. Whatever the reason, conducting meetings face-to-face is generally much more effective than doing so at a distance. You can develop important skills for improving communication.

Listening Listening allows you to gather the information that you are interested in. It has many facets that enable you to develop an understanding of another person’s thoughts and feelings beyond the facts given. Very importantly, it can transmit your interest in the person or the topic at hand. Some rules that can help you to become a more effective listener are

1. Focus your full attention.

2. Do more listening than talking.

3. Try not to be judgmental; instead, be understanding.

4. Try to get into the other person’s way of thinking.

5. Keep your responses to the topic being discussed.

6. Try to respond occasionally. Wherever possible, speak positively about the person’s strongly held beliefs.

7. Look for the principal points of the topic from both your own and the speaker’s points of view. Acknowledge your understanding of the topic from time to time.

Showing Empathy Empathy means attempting to place yourself in another person’s position, trying to iden- tify with what he or she is experiencing—his or her thoughts, feelings, and attitudes. It means listening, understanding, feeling, and communicating with increased sensitivity to someone else’s perceptions. Showing empathy has the potential to help you not only estab- lish a relationship with a person but also provide appropriate expert advice.

Establishing Trust Trust is the belief that you can rely on someone or something to perform as expected. Creating trust in financial planning comes from expertise—having a strong educational background and experience in a given area. In addition, it is generated by being truthful, by putting aside potential conflicts of interest, and by acting in the best interests of a person. Presenting a confident manner and appearance also helps. Finally, trust comes from attention—demonstrating your particular understanding and concern for the other person.

FIGURE 3.1 Nonverbal Communication

Source: clipart.com.

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When trust in another person is present, communication and effective planning can proceed smoothly. It can cause a client to believe that the result will be predictable with a low chance of a loss or an otherwise disappointing outcome. The use of empathy and value-free judgments also can help a client to be receptive to the planner’s advice. Having rapport with a client can often increase the client’s trust in the planner’s advice.

Example 3.1 The advisor knew many marketing representatives from financial services firms. They all had products to offer him, some attractive, some not, and the representatives varied in their degree of effectiveness in presenting the advantages of their offerings. When they came in, the advisor was polite yet aware of the representatives’ generally narrow sales focus. Dennis, a marketing representative for a major mutual fund company, was different. He asked to spend some time alone with the advisor to learn about his operations and goals for the future. At that meeting, the representative was very attentive and interested, asked for elaboration of certain points, and seemed to understand the advisor’s approach thoroughly. He conveyed knowledge, genuine interest, and even empathy for certain prob- lematic situations. Surprisingly, when asked how his firm’s products fit the advisor’s investment goals, Dennis said he would rather devote the time to focus on helping with the advisor’s overall business operations. A discussion of products could come later in the relationship. By the end of the meeting, the advisor was impressed. He was no longer wary of the interchange and made a mental note to give careful consideration to any recommendations Dennis would make. He asked himself what it was that distinguished Dennis from many other representatives and con- cluded it was the fact that Dennis truly listened and was focused on the advisor’s best interests.


The client interview can be the first activity performed in the financial planning process. The current use of widespread video calls might tempt both parties to hold the initial meet- ing remotely. Nevertheless, face-to-face interaction is suggested for the beginning of what might become a long and valued relationship. With a personal meeting, the client and the advisor can pick up more verbal and nonverbal cues that can help each decide whether to enter into an engagement. Going forward, video conferences may become practical if time demands prevent a physical meeting. It is at the first advisor–client meeting that goals are discussed and often established and data gathering begins. The interview process often has another purpose. Many advisors offer a free initial interview. This meeting allows the clients and the advisor to establish whether they wish to work together and to begin the relationship.

Communication is more important than many people think. As discussed, it is about not only delivering or receiving a specific message but also understanding a person and having him or her be open to accepting your message. You must strive to achieve trust and ongoing rapport partly by developing keen listening skills. Certain individu- als, particularly those in technical fields such as

finance, believe that concrete results speak for themselves. In contrast, many financial advisors believe that having rapport is a more important ingredient in whether clients remain or leave a firm than even investment performance. Clearly this message should be useful in virtually any field in which interaction with clients, supervisors, or co-workers is involved.

Professional Advice Communication

62 Part One Planning Basics

Fortunately, the interview process allows both relationship screening and data gathering to take place at the same time because both focus on clients’ interests. This interview process calls on the communication and listening skills and the establishment of trust nec- essary for a strong relationship. Counseling involves providing support for people. Interviewing is an integral part of the process; it helps frame the problems, interests, and background information required. To be successful, the interview process must have certain ingredients.

Preplanning Advisors should identify the purpose of a meeting. To be prepared, they should select top- ics to be covered and outline the questions to ask in advance. The interview room should be neat and free from distraction. Any background information about the person should be reviewed to help direct questions and establish rapport. Advisors should review techniques they have found to be effective. For example, they should plan to use desirable communi- cation techniques such as making reality checks at key points to ensure that the client, not the advisor, is doing most of the talking. Advisors must acknowledge that effectiveness often arises when clients believe they have a personal relationship with the advisors. Thus, fostering the relationship can be more important than demonstrating competence over and over again.

Beginning the Interview The interview should begin by making the client feel comfortable and relaxed. It may involve “small talk” that has nothing to do with the topics to be discussed but places the person at ease and, if possible, establishes rapport and common interests. The planner should mention the purpose of the interview, perhaps the approach and topics to be dis- cussed, and invite two-way communication that is as frank as possible.

Substance of the Interview To place the client in the appropriate framework for the rest of the interview, its substance should begin with a simple question. Generally, a variety of questions will then be asked. Open questions are those that permit answers that can go in any direction—for example, “What interests you in your life?” or “What are your goals?” Closed questions are shorter and ask for a specific answer, such as “How much money are you making currently?” or “Do you expect to go to graduate school?” Primary questions are the first ones in a new area—for example, “How much life insurance coverage do you have?” or “Do you have a list of your investments?” Probing questions seek to develop further information about a primary question—for example, “What types of life insurance do you own and why?” or “What does money mean to you?” Leading questions are those that guide a client toward an intended answer. Asking someone whether he or she would like a better-performing investment portfolio or is satisfied with current financial planning can lead that person to make a decision about hiring an advisor. There should be several advisor questions seeking elaboration to clients’ answers and, wherever possible, verbal exchanges that stress client interests. Interruptions of any type other than for clarification should be discouraged. Advisors should focus on listening to the client’s answers to their questions. These answers should lead to additional questions. By paraphrasing answers, advisors can con- firm that they are on the right track for proceeding. Feedback should be asked for at all points during the session. Although client interviews need structure, a certain flexibility is called for. When a client’s verbal answer and body language seem to conflict, further

Chapter Three Beginning the Planning Process 63

questioning is needed. It is often advisable to let clients continue their line of thought even though the answer to the question asked may range over several topics—the under- lying motivation and character of the client can come out in that reply. As mentioned, it is often best to be nonjudgmental about the client and to develop genuine interest and empathy in the exchange. Advisors should refrain from such counterproductive questioning techniques as allow- ing their questions to roam widely without establishing informational goals and structure, not using the time allotted efficiently, or allowing meetings to extend beyond schedule without good reason, which can be frustrating to both clients and advisors. In addition, advisors must avoid being either too shallow, too detailed in information gathering, or too direct in the line of questioning and not adjusting for sensitive subjects. Finally, advisors make sure the meeting isn’t too structured with the line of questioning entirely preplanned; with too much structure, clients’ wishes may not be revealed and information that is un- covered may not be developed.

Example 3.2 John was an excellent financial planner. He was bright, well qualified, and cared about his cli- ents. However, his interviews were inevitably too long, and he did not read the client’s frustra- tion with their length. After he adhered to a time limit on a first interview and left some questions to be handled later or eliminated and as he became more aware of his client’s body language, John became an effective questioner.

Conclusion Every meeting should have a conclusion. It may happen after advisors have asked all ques- tions intended or by indicating that the time is drawing to a close. A signal of the conclu- sion may be asking the client whether anything else should be covered at that time. Advisors should sum up the points covered during the meeting and establish a date for the next meeting or another plan for action.


Clients may request financial counseling at all stages of the planning process. At the begin- ning of the process, clients often ask planners what type of service they need. They may also request interim assistance. Financial planners may at any time suggest that clients not make any further investments with available cash until a specific part or all of the planning is completed. Financial counseling can be defined as the mechanism for assisting people in making their financial decisions. However, financial advising is sometimes considered to involve making the decisions for the client. Telling a client to buy a home with a fixed-rate, 30-year mortgage to lock in low monthly payments might be considered financial advising. Financial counseling might be thought to involve explaining the differences between fixed and adjustable rate loans and various loan repayment options, and then leaving the deci- sion up to the client. The thought in counseling, then, is to provide personalized service, perhaps including nonfinancial support and to leave the ultimate decisions in the hands of the client. As a practical matter, counseling and advice often are combined with little distinction between the two. The advice should not be abstract but tailored to the client’s interests. When clients show some resistance to the advice, the planner should attempt to under- stand fully the cause of the resistance and, when appropriate, persuade those clients that their ways of viewing the matter may not be in their best interest. The planner should give specific reasons as to why this is so.

64 Part One Planning Basics

Alternatively, it may be best to change the advice. Sometimes when clients’ resistance is received, just listening and acknowledging that you understand the client’s point of view is all that is needed. Frequently, “venting” or just talking about the situation is the client’s only intention. Resistance indicated by either words or body language should generally be dealt with politely but discreetly with a question about where the difficulty comes from.

Example 3.3 Doug was conducting an interview with a new client. At the end of the interview, the person had the choice of taking pension monies in the form of a lump-sum distribution or an annuity of yearly payments for life. Doug stressed the benefits of a lump sum, which he believed would provide higher income over the longer term. He noticed that the client’s face tightened when he mentioned this and that the client spoke of the safety of an annuity. Doug then checked himself, recognizing that perhaps he had let his own interests concerning the lump-sum option color his thinking. He immediately shifted his approach, presenting the benefits of an annuity to the client with a low tolerance for risk.

Thus, advisors should be aware of their own biases and ask themselves whether their advice is extending beyond hard financial practices and the client’s wishes to their own preferences. If so, advisors should question whether their own preferences are in the cli- ent’s best interests. Whenever possible, planners should make strong efforts to regard the client positively and to demonstrate this in interactions. At the same time, planners must be genuine be- cause forms of communications such as body language often indicate their true feelings. If a client feels the advisor is not genuine, the entire relationship, which is based on trust, can be undermined. At a minimum, any unfavorable judgments should be set aside for the bal- ance of the consultation.


Goals are the results that we would like to achieve. Financial planning activities are under- taken based on stated goals. In this chapter, we provide a broad overview of the topic. In Chapter 18 we deal more extensively with life planning—a goals-oriented approach that extends beyond money issues to strategic matters for verification and realization of life- time objectives.

Often in financial planning, the difference between counseling and advising can have more to do with the personality of planners than with their back- grounds or even their use of a financial plan. Some planners view themselves as assisting people in making their decisions. They can be extremely sensitive to people’s needs, and let financial rules take a back seat. Other planners view themselves as experts whose advice is correct and should be followed in all instances. Many planners find themselves somewhere in between. They follow rules about providing the best

financial advice but are flexible in their recommen- dations and bend those rules to accommodate cli- ents’ desires. Clients themselves can often determine through the initial interview which type of financial planner they are dealing with and select the one who best suits them. Of course, many financial plan- ners are able to accommodate themselves to the style the client prefers, which can be an attractive trait. Despite the different types of planners, many provide a combination of advice and counseling as circumstances dictate, which may be why the word advisor is often used to encompass both aspects.

Practical Comment Counseling versus Advising

Chapter Three Beginning the Planning Process 65

Approaches to Goals How do we establish our goals? The answer depends in part on which discipline we choose.5 Sociologists are concerned with the study of groups, so it should not be surprising that sociologists believe that our goals are influenced by the way we were raised by our families and other groups of people in our environment. Sociologists might theorize that we strive to maintain our status relative to our peer groups—our friends, families, and business associates. In contrast, biologists might say that, to some extent, we are programmed by our genetic makeup to strive for certain objectives. Psychologists who study motivation might assume that the underlying goal of most human behavior is to have as many pleasurable experi- ences as possible. Clearly, different people take pleasure from different activities. Some work to achieve the most money or fame. Others strive to allocate the greatest proportion of their life to leisure activities or to have fulfilling personal relationships. Moreover, our goals can change over time. For example, some goals have a life cycle component. We may want to play as hard as we can when in our 20s and strive to relax by a pool in our 70s. Economics translates goals into utility (pleasure) terms and then attempts to quantify them in objective terms by placing a dollar value on them. Quantifying goals helps to bring scientific measurement to the discipline. Finance also expresses most things in money terms. For example, in financial terms, the goal of business is to make the most money possible subject to a given level of risk.6

To demonstrate the wide array of interpretations according to a specific discipline, con- sider the following analysis of possible reasons for having a child:

1. Sociologically, it is what the group expects.

2. Biologically, it is an inner need that has to be fulfilled.

3. Religiously, it is what is expected by a higher power.

4. Psychologically, it provides happiness.

5. Economically and financially, it can be considered a major long-term overhead cost similar to a capital expenditure or the need to have someone to care for us in old age.

6. In ordinary terms, it can be viewed as a way to form a lasting, enjoyable, emotional relationship.

At first glance, the economics and finance approaches might seem somewhat narrow and unfeeling. Economists and finance people know that they are simplifying human motivations by translating them into common dollar terms. But doing so permits scientific measurement to go forward and enables us to gain additional insight into how human beings operate and how to improve their operations.7 Because this is a financial text, in most instances we use a finance business approach. In the discussion that follows, we take a broad perspective concerning goals. For example, the psychologist Abraham Maslow believed that people first try to satisfy their basic, or physiological, needs—food, shelter, and clothing. If these are taken care of, people move on to satisfy their need for safety. The next level involves social needs, such as the desire for belonging. If people have enough resources, they attempt to satisfy their higher needs of both self- esteem and esteem from others. The highest-level need, according

5 For a review of how other disciplines approach goals, see Michael Jensen, Foundations of Organizational Management Strategy (Cambridge, MA: Harvard University Press, 1998). 6 Publicly owned companies’ goal is to maximize the stockholder wealth figure that combines profit and risk. 7 For a discussion of simplifying assumptions, see George Stigler and Gary Becker, “De Gustibus Non Est Disputandum,” American Economic Review 67, no. 2 (March 1977): 76–90.

66 Part One Planning Basics

to Maslow, is for self-actualization, which involves achieving personal goals in life. Figure 3.2 shows an illustration of Maslow’s hierarchy of needs in a pyramidal form.8

On a more pragmatic level, you might establish three levels of goals in each part of the financial plan: minimum goals, satisfactory goals, and higher-level goals. If you don’t reach your minimum goals, you would be distinctly disappointed. Reaching goals that you target and would be pleased to attain provides satisfaction. Higher-level goals, if you achieve them, would give you pleasure beyond your expectations. For example, your minimum goal could be to rent an apartment in a good neighborhood in the suburbs. Your satisfactory goal may be to live in an attractive home in a similar neighborhood. Your higher-level goal might be to have a luxurious vacation home in addition to the suburban house. The approach is termed the money ladder.9

This book often uses the term standard of living or economic well-being as finance’s practical imple- mentation of the word money. The goal of financial planning is to help people achieve the highest stan- dard of living possible. Standard of living has two meanings. In strict financial parlance, as you’ve seen, it means making the most money possible. In more common usage, it can mean achieving an attractive balance of life’s factors. Financial planners know that their clients’ goals extend beyond just acquiring material items. For example, planners don’t often recommend that a client take a permanent second job to earn more

money. Planners rely heavily on financial numbers because that is frequently what they are hired to do and because money often has a strong place in overall goal achievement. Yet many financial planners manage to blend money with other goals. In its second—broader— meaning, standard of living is a relative term that depends on individual values. In this instance, the term quality of life is perhaps closest to the  meaning of standard of living. The goal, especially when material comforts have been achieved, can be one of satisfac- tion with lifestyle and accomplishments.

Practical Comment Goals and Standard of Living


(the need for achievement of personal goals)

ESTEEM (the need for self-esteem, recognition by others)

SOCIAL (the need for belonging)

SECURITY (the need for safety)

PHYSIOLOGICAL (the need for food, shelter, and clothing)

FIGURE 3.2 Maslow’s Hierarchy of Needs

8 For an extensive discussion of Maslow’s hierarchy see Lewis J. Altfest, “Chapter 10: Motivation and Satisfaction,” 171–188. 9 Lewis J. Altfest and Karen C. Altfest, Lew Altfest Answers Almost All Your Questions about Money (New York: McGraw-Hill, 1992). A variation of this approach is used in Chapter 19, Appendix III of this text.

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Goals can be separated into three time frames. Short-term goals are those you intend to achieve within one year—for example, being more selective in purchasing goods and appli- ances that may not be needed or saving for a vacation. Intermediate goals are completed in one to four years—saving for the down payment on a car or a home, for example. Long- term goals are those you expect to accomplish in five years or more. Examples would in- clude saving for a child’s college education and having enough money to retire comfortably. The following list is one financial planner’s method of helping a person select the life values that are important to him or her. He suggests that that the individual choose three to five of these items and rank order them.10

Life Values

• Achievement: to accomplish something important in life.

• Aesthetics: to be able to appreciate and enjoy beauty for its own sake.

• Authority: to be a key decision maker directing priorities.

• Adventure: to experience variety and excitement.

• Autonomy: to be independent, have freedom.

• Health: to be physically, mentally, and emotionally well.

• Integrity: to be honest and straightforward, just and fair.

• Friendship: to have close personal relationships, share with family and friends.

• Pleasure: to experience enjoyment and satisfaction from activities in which I participate.

• Recognition: to be seen as successful, receive acknowledgment for achievement.

• Security: to feel stable and comfortable with few changes or anxieties in my life.

• Service: to contribute to the quality of life for other people.

• Spiritual: to grow to have harmony with the infinite source of life.

• Wealth: to acquire an abundance of money/possessions; to be financially independent.

• Wisdom: to have insight, to be able to pursue new knowledge.

As you can see, people’s goals in life can differ greatly. Moreover, your goals can be altered over time by practical experiences—for example, the degree of your success in reaching previous objectives and your attraction to new ideas. Many people who are com- fortably in the middle class find that money goals diminish in importance as they age. We will examine the issue of goals further in Chapter 18.

10 Adapted from Ken Rouse, Putting Money in Its Place. Dubuque, IA: Kendall/Hunt Publishing, 1994.

Goals may not always come to mind easily. You may need to think them through. Sometimes what you think of as your goals are just short-term consider- ations. For example, you may seek professional assistance to help save for a car; your real goal, how- ever, may be to establish a savings structure to allow

you to maintain the same lifestyle both before and after retirement. At other times, your goals and needs may be in conflict. Your goal—continuing to spend, for example—may be unrealistic, whereas the consequences—taking on debt—suggest a different need and course of action.

Practical Comment Analysis of Goals

68 Part One Planning Basics


Data gathering is accumulating the information that is needed to perform personal finan- cial planning objectives. Therefore, before beginning our tasks, we must establish the particular goals that determine the type of planning to be done. For example, an investment review will require much more specialized and less extensive material than a comprehen- sive financial plan.11 We also must ascertain needs where they differ from goals and develop a sense of priorities among goals and needs. The data to be received may come from written documents or obtained by questioning other advisors retained by the client, such as an accountant, lawyer, and insurance repre- sentative or in reviewing an appropriate questionnaire that has been filled out. Many plan- ning firms have a form or a set of forms for new clients to complete, and those forms will indicate what information the client needs to provide. When the work is being performed for clients, an interview of the person or couple is a highly significant part of the process. We look at interviewing procedures for financial planners in the next section. The information categories for a comprehensive financial plan or comprehensive review fol- low the major parts of a plan. Even with a segmented financial plan (one that covers a lim- ited or specialized portion of all financial activities), the household’s overall financial condition should be established. Some of the key areas and information needed are outlined in Table 3.1. The interview and the data-gathering process have other objectives as well. At this point in the process we want to establish how financially sophisticated the clients are. For ex- ample, are they able to understand the workings of common financial instruments such as stocks and bonds? Can they distinguish the risks of various investment alternatives? Do they know the differences among the various types of life insurance? A preliminary assessment of their risk tolerance can be established. A completed ques- tionnaire is often used to determine whether clients think of themselves as conservative, moderate, or aggressive with their finances. This evaluation may be a self-assessment of risk preference either overall or relative to the “average person.” Risk should be viewed not only in terms of investment—stock and bond risk—but also in terms of overall house- hold risk, including such things as need for insurance, personal practices, and career goals. Toward the end of data gathering, the advisor should be aware of any factors that distin- guish this client’s situation from that of others. For example, is there a particular focus on client education or on providing children who have severe learning disabilities with life- time support? Will there be a particular difficulty in obtaining reliable revenue and operat- ing cost figures? Do the clients have particular personal problems, such as excessive gambling, drinking, or perhaps excessive spending habits? Full data gathering can take some time. At the completion of an initial interview and prelimi- nary data gathering, however, the advisor is ready to indicate, based on client’s interests and needs, what he or she thinks is the appropriate scope of the engagement and what the cost will be. If the engagement calls for the client’s investment assets to be managed, percentage-of- assets fees may be charged at regular intervals. Alternatively, an hourly rate can be established, sometimes with a minimum and maximum cost indicated. In some cases, a flat fee is provided for a fixed service. The client ultimately decides, generally in consultation with the advisor, whether the scope indicated should be accepted or modified. Clearly stating the specific terms of the engagement, what is included and what is not, is very important.

11 Sometimes establishing goals is a part of the preliminary data-gathering process. The approach may be to ask some preliminary questions that help develop the scope of the work and then develop the specific goals. Detailed data gathering then follows. Alternatively, goals may come from an advisor’s comprehensive review and assessment of needs or from modifying preexisting goals.

Chapter Three Beginning the Planning Process 69

Risk tolerance can sometimes be a difficult item to assess. People may have different responses depend- ing on such factors as the criteria used, their finan- cial sophistication, the way a question is framed, and the investment climate at the time. The author had one client who described his investment risk toler- ance as moderately aggressive; when pressed, he indicated that he would consider a certificate of deposit as providing the security he associated with that risk tolerance. Behavioral variables often enter these assessments. People commonly change their long-term risk tolerance

based on shorter-term investment performance. They also may ignore such basic concepts as the higher the return sought, the higher the risk of the investment. For example, when asked to provide relative ratings from 0 to 100 for what was most important to them, including safety of principal and high returns, a signifi- cant number of clients put 100 for both. Wherever possible, advisors should use a variety of criteria in determining risk tolerance, including the client’s current practices; when a client’s re- sponses are inconsistent or not logical, press further. We consider this topic in more detail in Chapter 10.

Practical Comment Tolerance for Risk

TABLE 3.1 Selected Data Gathered for Comprehensive Financial Plan

Source: Levin, Ross. Implementing the Wealth Management Index Tools to Build Your Practice and Measure Client Success. Vol. 144 of Bloomberg Financial. Hoboken, NJ: John Wiley & Sons, 2011.

Type Selected Information Needed

Background of household members Personal information: name, number, and ages of household members; educational attainment; type of job; personal traits and beliefs; advisory services used; and so on.

Balance sheet Current assets and liabilities.* Cash flow planning Current projected income and expenses, both for daily items and for capital

outlays. Income tax planning Income tax return for the past year and perhaps the past three years. Debt Existing home mortgages,credit cards and credit lines, such as home equity

loans. Investments A detailed list of bank, brokerage, mutual fund, and other investment

accounts and specific holdings. Current market value and projected outlays for home and details of other

investments. Establishment of investment risk tolerance. Retirement planning Retirement accounts and retirement savings. Rates of inflation and rates of return, retirement goals, government benefits. Estate planning Copies of wills and trusts. Establishment of titling of assets. Intended gifting

policies and those for estate distribution at death. Risk management Copies of all insurance policies. Intended insurance coverage. Other risk

management procedures. Determination of overall household risk tolerance. Employee benefits Copies of description of all company benefits. Amounts and investment alternatives for pension plans. Family planning Current number of household members. Marital and children planning versus

household members today. Educational planning Types of plans and amount of assets in place. Prospective costs for college and, in the case of children, the amount or

percentage to be funded by the parent. Specialized planning Description of particular planning needs for the individual household. Other Health, possible inheritances, broader family responsibilities and obligations,

personal nonfinancial problems.

* Pro forma future statements will come from planning procedures.

70 Part One Planning Basics

When data gathering, goals, and needs have been established, at least preliminarily, and a time horizon determined to satisfy each individual, the advisor is able to identify how the household operates and the ways that financial planning activities can help. In analyzing each part of the plan, the advisor must always keep in mind the overall goals. That process is some- times referred to as determining where we want to be as compared with where we are now. The activities given in the next sections of the book provide the building blocks for how to get there.

Back to Dan and Laura DATA GATHERING, GOAL SETTING, AND COMMUNICATION This meeting with Dan and Laura was set to further discuss personal goals that both seemed anxious about. They brought with them what they said was the completed question- naire. Both were enthusiastic about the coming planning process. They thought that I had handled the initial interviews very well. Dan said he particularly liked the way I had moved the meetings along smoothly and handled their recurring differences of opinion easily. He said he was having difficulty com- municating with an important new client and would like me to give him some tips on suc- cessful communication and interviewing techniques after discussing goals.

My response to them was: Thank you for your kind comments about our initial interviews. I will strive to meet your expectations. Before I discuss communication matters, let me mention that data gathering is an arduous, detailed process. I know that filling out the questionnaire isn’t fun. However, it must cover all parts of the financial plan and anything financial that you care to add. The questionnaire you sent back wasn’t complete, and I frankly thought you hadn’t given it your full attention. The questionnaire encompassed a large part of the information that I will need to process. Because a financial plan can only be as good as the figures and forethought that goes into it, I am asking you to review it again—this time more carefully. If you have any questions about it, please let me know. If you prefer, we can sit together while you fill it out. Now, let me turn to goals. Goals can be looked at in specific money terms. For example, how much will it cost for a vacation or a down payment on a home? Goals also can be viewed in terms of completion over a time frame—for example, short versus long term. For some people, goals change with income or education so that basic goals are transformed into the fulfillment of higher needs, such as self-esteem and self-actualization.

Notice that the initial steps in the financial planning process can sometimes be shifted. Traditionally, set- ting the terms of the engagement is thought of as being performed first, followed by setting the goals, and then data gathering. From a legal standpoint, this approach is correct. When no fixed service is being offered, however, the advisor may not know what is needed and what the cost will be. Many advisors, of course, offer free

initial consultations whose purpose is to establish not only the particulars of the engagement but also whether the two parties desire to work together. What can happen, therefore, is a preliminary or even fairly detailed session on goals and data gather- ing prior to establishing contract terms. Certain goals then can come from data gathering. Once a contract is signed, the goals are often examined in more depth, and more detailed data gathering begins.

Practical Comment Steps in the PFP Process

Chapter Three Beginning the Planning Process 71

Finally, the process of setting goals can be expressed in minimum, satisfactory, and higher-level forms—often based on how hard we want to work and sacrifice today’s stan- dard of living for tomorrow’s. Your financial plan will provide the best way for you to achieve your goals. Goals mo- tivate you to plan your financial future in an orderly way. As you indicated to me in our first meeting and the one we just had, your goals are as follows:

1. To get out of credit card debt and repay student loans as soon as possible.

2. To be less concerned about the future by planning now.

3. To have two children and maintain the standard of living you have today.

4. To purchase a house in the not-too-distant future.

5. To be financially independent by age 55.

6. To have your insurance needs examined.

7. To provide money for both children to go to college.

8. To leave $100,000 to each child in your will.

9. To develop an overall asset allocation for your investments.

We will construct your financial plan with these goals in mind. As you requested, I will develop each part of the plan separately. I will explain why I made my recommendations in enough detail so that you can provide me your reactions prior to the final integration stage for completing the plan. Be aware that goals are often modified as more information on fi- nancial capabilities becomes available. Therefore, we are likely to return to this subject. Dan, as far as communication and interviewing strategy are concerned, I used many established techniques in our first interview. I attempted to make my office very quiet and hospitable for frank discussions. Our first conversation was not related to business; rather, it was designed for us to get to know each other and establish a relationship. The questions that followed were simple and open ended so that I could become familiar with your inter- ests and personalities. I was very much aware of your gestures and facial expressions. Laura, yours were very natural and free of tension. Dan, your face and folded arms suggested that you weren’t comfortable with the process of open communication or perhaps with me. That is why I spoke to you in depth first. Perhaps the singular thing I did to win you over and make you relax was to listen intently. You may have noticed my comments and gestures, which sought elaboration and expressed a nonjudgmental approach to what I was hearing. I knew right away that the two of you had different opinions. I listened to you both and tried to empathize with what I heard. In other words, I tried to look at your problems from your own perspectives. I’ve found that if I do that, both parties with conflicting opinions believe they have had a hearing, are taken seriously, often sympathetically, and are then ready to engage in open communication. Although it is early in the process, I tried to counsel you and to support you in making your own decisions. My comments were simple and clear and encouraged feedback on how I was doing. I will continue to counsel you, but I’ll also express my opinions as an advisor, which I believe you want me to do. You may notice that our first interview had a beginning, a substantial content-contained body of discussion, and a conclusion with my summation of what had been covered and what the next steps would be. Dan, I believe that if you follow these steps, particularly the ones that concern listening and focusing on your client’s needs ahead of your own, you will do just fine. I hope this helps.

72 Part One Planning Basics

College Student Case Study and Review: Amy and John BEGINNING THE PLANNING PROCESS At this meeting, I told Amy and John that the preparations for the actual planning process would begin. Behavioral finance, communication, interviewing, goals, and data gathering were up for discussion.

Behavioral Planning First I mentioned that behavioral finance was a much-maligned area of financial planning. Some people thought it was bringing a “shrink” mentality into a numbers-oriented profes- sion. However, people don’t always function logically, like a machine; they act, well, like humans. Behavioral finance concentrates on human behavior as it pertains to finance. Behavioral financial planning takes it a step further and indicates how people can modify their behavior to operate more efficiently to better meet their goals. Amy, you finally seemed engaged and asked to hear more whereas John attempted to check his e-mail with his phone “discreetly” under the table. I mentioned we would later devote a whole session to the topic, but at that time we would discuss a few things. Our behavior is shaped by our culture as represented by our social, ethical, and religious backgrounds. Our peer groups strongly influence how we behave. Our age and positioning in our life cycle are extremely important. Our interests and preferences change over our life cycle as we go from young (age 18–42), when we are interested in relationships and careers, to middle age (43–67), when we engage in more refined planning, especially for retirement, and to seniors (68 and be- yond), when we retire, spend down our assets, and engage in estate planning. Finally, our particular personality influences how we react to our environment and, for planning purposes, how much risk we are willing to undertake. As we can, see behavioral planning extends well beyond just how much money we expect to make.

Communication Communication, defined as the ability to transmit a message successfully to someone else, is highly important in all personal interaction, financial planning included. The two main types of communication are verbal and nonverbal. Verbal communication includes trans- mitting messages through the human voice and nonverbal communication is everything else. Body language, which transmits messages through gestures such as a frown or a shrug, is one example of nonverbal communication Proper communication helps in ex- pressing facts, sharing opinions, and developing a relationship with a person. Listening is the most useful tool in understanding and persuading someone as well as for gathering information. Effective listening requires a person’s full attention. Being empa- thetic means placing oneself in someone else’s shoes; it allows personal financial planners to understand and relate to their clients. Aside from having financial expertise, planners must develop trusting relationships with their clients through being truthful, confident, and devoting attention to them. These traits are highly effective communication tools.

Interviewing Interviewing is often the commencement of the financial planning process. It combines a discussion of goals and data gathering in a multipart process consisting of:

1. Preplanning—Determine what should take place.

2. Beginning the interview—Make people feel comfortable and explain the process.

Chapter Three Beginning the Planning Process 73

3. Substance of interview—Start with simple questions and progressively ask more in- depth ones.

4. Conclusion—Give a signal that the interview is ending, sum it up, and set future steps.

Goals Goals are the results you desire to achieve. Goal setting is often established or at least started in the initial interview. One overall approach was set by Abraham Maslow, whose hierarchy of needs moves from the simplest to the most complex goals. The simplest needs must be satisfied first before moving up the hierarchy to more complex aspirations. The categories in order are:

1. Physiological—Food, shelter, clothing

2. Security—Feeling of safety

3. Social—Need for belonging

4. Esteem—Need for self-esteem and recognition by others

5. Self-Actualization—Need for self-achievement

Data Gathering This is the process of accumulating basic information needed in the PFP process.

Selected Data Gathering This procedure includes getting basic personal information including, among other things, a household balance sheet showing assets and liabilities, income and expense figures, tax return, debt, investments, retirement savings, wills, trusts, insurance policies, and em- ployee benefits. Often this basic information is sketched out initially and then filled in later.

Summary Communication, data gathering, and goal setting are interrelated topics. The objective of these three topics is to begin the planning process smoothly so that goal establish- ment and data gathering occur correctly and the required information is received. This involves

• Understanding the particular needs and behavior of the people for whom planning is to be done. They differ because of such variables as culture, age, family background, and personality.

• Developing sound communication skills such as reading body language, listening care- fully, and placing oneself in another person’s shoes.

• Establishing trust by being knowledgeable and honest and acting in the best interests of the client.

• Preplanning interviewing procedures. Start by making the client feel comfortable, cover the topics intended, and have a conclusion that includes summing up and establishing the next step in the planning process.

• Goals are the focal point of PFP. There are normally many types of goals, and these depend, to a great extent, on a person’s life values.

• Data gathering is developing the information necessary to perform PFP. Each area of the plan contributes.

74 Part One Planning Basics

Key Terms behavioral finance, 57 behavioral financial planning, 57 body language, 59 communication, 59 data gathering, 68

empathy, 60 financial counseling, 63 nonverbal communication, 59 personality, 58 segmented financial plan, 68

standard of living, 66 trust, 60 verbal communication, 59 verbal message, 59

1. What is behavioral finance?

2. How does behavioral finance differ from quantitative finance?

3. Contrast the interests of young people and seniors.

4. What does nonverbal communication mean?

5. Why is listening important in the financial planning process?

6. What are four techniques that are helpful in becoming a good listener?

7. How do you establish trust?

8. Why is preplanning for an interview important?

9. What are some attractive interviewing techniques?

10. How does financial counseling differ from financial advising?

11. How should resistance to a question or recommended course of action be handled?

12. Why are goals important for financial planning?

13. What are some of the broad financial goals of people with whom you will come in contact?

14. How can financial planning goals be broken down into minimum, satisfactory, and higher-level components according to parts of the financial plan?

15. What does standard of living mean to you?

16. How do financial and personal interpretations of financial planning differ?

17. Are goals more short-term or long-term oriented? Explain your answer.

18. How is Maslow’s hierarchy of needs related to income?

19. What is data gathering?

20. Why is data gathering important?

21. What are two pieces of data that are needed in each of the six financial planning areas?

22. Which types of data should be gathered at an initial interview and which should be left for future meetings?

23. How do commission communications vary from other types?

24. What is the difference between feeling sympathy and empathy for the client? Is one more valuable than the other? Why?

25. What would you consider to be the financial equivalent of Maslow’s hierarchy of needs? What are the basics? What comes last?

26. What is the significance of choosing to construct a segmented financial plan?

27. How would you interact and advise a client with goals you personally find outlandish but that the client values greatly. Creating a mock dialogue could be helpful.


Chapter Three Beginning the Planning Process 75

Case Application DATA GATHERING, GOAL SETTING, AND COMMUNICATION Brad and Barbara made an appointment to see me concerning their own financial situa- tion. They were a newly married couple in their early 20s. Barbara came from a family whose parents had children early in their lives; the women were full-time mothers until their children were in college. Barbara had no career ambitions of her own and wanted to have children. Brad was an artistic person who had graduated with a B.A. in English. He was thinking of a career in the arts but didn’t yet know which area. He wanted time to pursue the alternatives and have children later when he is in his 30s. Brad and Barbara seemed to get along well, and both showed unusual understanding of their and their spouse’s personalities.

Case Application Questions 1. As a planner, what communication techniques would you review to prepare for the

meeting with Brad and Barbara?

2. How would you open the interview?

3. Assuming you didn’t know any of the information about Brad and Barbara, what data- gathering questions would you ask?

4. Assuming that you knew the information, how would you question the couple about their goals?

5. Would you take sides on their differing goals? Why?

6. What approach would you use for the meeting? Would you be closer to a counselor or to an advisor?

7. Suppose that before the meeting, Brad and Barbara said they weren’t sure that you were the right person for the position and that they might interview others. How would that influence the interview process? Give some examples.

8. Suppose you found yourself doing most of the talking. What might that mean? What would you do?

9. How would you end the meeting?

10. What are Brad and Barbara’s goals?

11. What type of information would you ask them for in their first meeting?

12. Assume that you were doing a financial plan for Brad and Barbara. Complete the goals section of the financial plan.

Part Two

Ongoing Household Planning 4. Household Finance 5. Financial Statements Analysis 6. Cash Flow Planning 7. Debt

This section discusses basic household operations. In that discussion, Chapter 4 presents financial planning theory with its two major themes: the household enterprise with its businesslike characteristics and the decision making that integrates all assets and obligations. You will learn that the household produces goods and services and generates a kind of profit. Keep in mind that the goal of the household enterprise is to operate as productively as possible. Doing so leads to the highest standard of living you can achieve. The mandate of personal finan- cial planning (PFP) is to help make that happen. Chapter 5 details the analysis of financial statements. By constructing and analyz- ing financial statements, you can make an appraisal of where you are financially at the time. The statements also can be financial projections used to help point the way to necessary future actions. Methods of developing financial statements and evaluating the results are both discussed. Chapter 6 presents cash flow planning. Cash flow is the resource generated that is used in virtually every personal financial planning activity. When we are operating efficiently, we generate the highest cash flow possible given time and risk limitations. The focus in Chapter 6 is on savings, a difficult process for many, and financial ratios, several of which are cash flow–generated, that help deter- mine our financial health. Chapter 7 describes debt and the ways it is and should be used in the household. For many, incurring debt through the use of credit cards has become a normal household function for obtaining cash and affecting ordinary transactions. The advantages and disadvantages of credit card debt is presented. Knowledge of daily household operations and planning for them, as presented in this section, will set the stage for more sophisticated analysis throughout the book.


Chapter Goals

This chapter will enable you to:

• Apply household finance and its economic and financial underpinnings to improve your personal financial planning (PFP).

• View the household as a functioning enterprise.

• Start to apply business principles to PFP.

• Implement cost of time and life cycle theory principles in personal financial decision making.

• Differentiate various types of household outlays.

• Begin to understand personal financial planning theory and total portfolio management (TPM).

Dan and Laura were intrigued by their friends’ comment that the key to their financial suc- cess was that they ran their household as a business. Dan liked the idea of operating the household in that way and wondered if there was any theory of personal financial plan- ning. Laura didn’t understand why her husband was interested in all that “theoretical stuff.” Wasn’t financial planning just a straightforward process?

Real-Life Planning


Henry was a sports star known for his talent and temperament. He was a “control freak,” unable to delegate any but the most technical matters to others. Henry’s first meeting with the financial planning advisor was held in Henry’s sports car in the parking lot after a game. Unfortunately, Henry was as frugal and unschooled in personal financial matters as he was flamboyant and sophisticated in sports. He wrote all checks himself and could never find the time to pay his bills when they were due. Unopened bills lay on his floor. He never reconciled his bank statement, and sometimes large sums of money lay dormant in non- interest-bearing bank accounts. The advisor told Henry to think of himself as running a business enterprise. The main asset of his business was his own revenue-generating ability through competing in games and serving as a spokesperson for various products. His expenses were the food, cloth- ing, shelter, and other costs necessary to keep his own household operating smoothly and healthily. The remaining cash flow would be used for fun activities and savings to continue to generate revenue for the time when his athletic abilities would no longer be in demand.

Chapter Four

Household Finance

Chapter Four Household Finance 79

The advisor said that Henry was missing out on two opportunities. The first was the op- portunity to earn higher sums by investing his money judiciously and through handling day-to-day financial functions properly. It would require money to hire the proper finan- cial people to help him with this. While his operating costs would rise, his enterprise would likely provide higher returns for use after athletic retirement. The second opportunity was the chance to eliminate his fear of the future. The advisor would provide a financial plan that would detail ways to both raise his quality of life today and protect him in the future. The advisor had already concluded that these goals were achievable. To take advantage of these opportunities, Henry would have to relinquish some control to others although he would still be in the financial driver’s seat. The advisor told Henry that, in effect, there was a cost to the time he was devoting to his household activities. He could use the time freed from this process to earn more money or to relax more. Henry didn’t immediately say whether he was retaining the advisor. Instead he turned on the igni- tion, drove out of the parking lot, and, when he got to the highway, launched into a broader discussion of his financial concerns. The advisor took notes and thought of the challenge associated with setting Henry on the right financial path.


Mary owned a successful web design business. She started it in college in her apartment after interning for a large firm during her freshman year. The business grew rapidly be- cause of her ability to accept both large and small clients and deliver high-quality creative work on time and at reasonable prices. Pretty soon she had both full-time employees and independent contractors working for her. She had accumulated large profits that she used to set up a pension plan and to purchase a home. The income was so large that they cov- ered her frivolous expenditures and large credit card liability. Then came the 2008–2009 recession, and Mary at age 25 was facing a crisis. She saw herself as an artist and had little experience in financial matters. When the stock market declined sharply, she became nervous and sold all her equities that were riskier than average at a 70 percent loss. She had bought her home at the top of the market in 2007 with only 5 percent down. She was well “underwater” on the home with a large mortgage to pay each month. Perhaps worst of all, her business deteriorated sharply because of the recession. After laying off her entire staff, Mary did some soul searching. She decided to invest in herself by pursuing an MBA; her interesting personal history enabled her to get significant scholarship money. Although she kept her business functioning, she examined other alter- natives including part-time work in two new activities. In her finance and management courses, she began to see the parallels between her business and household activities. Both required logical structured thinking and acting with the goal of generating the highest free cash flow for her benefit over time. She decided that none of her other career alternatives could compete with her interest in her own business. Helped by a marketing course that discussed the principles of product differentiation and branding, her business gradually began to recover. She placed her pen- sion back into equities and resolved not to try to time the market. She gradually paid off her debt. Her new mantra was to see herself as a creative person with smart business in- stincts and who operated her household as a business.


Personal financial planning didn’t emerge full blown from a shell. This chapter traces the development of household finance and personal financial planning theory. It begins by establishing that the household is the proper organizational structure for an individual’s

80 Part Two Ongoing Household Planning

financial activities. We then look at the economic theories that have led to the household financial approach. You will learn about the cost of time and how household outlays can be separated into two parts: maintenance and leisure. With this material as background, we discuss the household as an enterprise with similarities to a business. Household finance as an approach that embraces the entire book is then described and linked to personal financial planning. A theory of personal financial planning with its active arm, total portfolio management, extends and com- pletes the chapter. Knowledge of these topics will enable you to have greater insight into PFP and its inte- grated core and to increase your understanding of the material to come in future chapters. It also can result in your making better decisions in practice.


The household represents an organizational structure that unites its occupants. We are interested in the household structure because it can best describe the combined financial actions of its occupants. Just as structure or form affects a business, so too the form of a household can affect its financial operations.1 The household also can provide an opportunity for logical decision making by its members, which is, of course, a principal goal of personal financial planning and of this book. The household can be described as a structure for one or more people who live in the same home. This definition is very broad and can include people who share nothing other than the same roof.2 A similar definition is often used by the U.S. Census Bureau, which publishes many economic statistics by household. For our purposes, a more meaningful definition of household is an organization of one or more people who share a dwelling and share financial and other resources intended for the well-being of its members.3 This definition requires more involvement and sharing to qualify as a household with multiple members. In other words, the household is the princi- pal organization intended to handle the financial and other personal activities of one or more people and to foster the achievement of their goals.4

The household comes in many organizational forms, which, as with a business organiza- tion, influence its financial, legal, and tax situations. For example, financial efficiencies can result from a multiperson household through reduction in income fluctuation, specialization

1 Many introductory texts in business finance incorporate a description of a business structure, and the CFP curriculum requirement does as well. 2 John B. Taylor and Akila Weerapan, Principles of Microeconomics, 7th ed. (Mason, Ohio Cengage Learning, 2011). 3 For a discussion of qualifications for a household, see W. Keith Bryant and Cathleen D. Zick, The Economic Organization of the Household, 2nd ed. (Cambridge: Cambridge University Press, 2005). 4 In traditional economic theory, all members of the household are assumed to have interests identical to those of the overall household (see Paul Samuelson, “Social Indifference Curves,” Quarterly Journal of Economics 70, no. 1 [February 1956]: 1–22), or the outcomes are as if they did (Gary Becker, “Altruism in the Family and Selfishness in the Market Place,” Economica, n.s., 48, no. 189 [February 1981]: 1–15). For an update, see Susan M. Bianchi, “Family Change and Time Allocation in American Families,” The ANNALS of the American Academy of Political and Social Science 638, no.1 (November 2011): 21–44. Thus, it is possible to speak of household and individual interests interchangeably—a procedure that, for the most part, we follow in this book. In the book’s final two chapters, however, we consider an alternative view. Any alternative view of household interest that does not incorporate a one-voice theory can be considered roughly similar to an approach that does not align worker and owner interests in a business in its traditional goal of maximization of profits.

Chapter Four Household Finance 81

of tasks, and economies of scale. If two people work, they reduce the risk of a stop in income in the event of sickness or job layoffs. Specialization in household activities can allow tasks completed more quickly and with higher quality. Sharing fixed costs for shelter and other goods offers greater economies of scale. This thought is reflected in saying, “Two can live as cheaply as one.” A summary of types of household structures and their effect on financial, legal, and tax matters is presented in Table 4.1. Over the past half century, the composition of households in the United States has changed. For total households, the percentage of stereotypical nuclear families—married couples with children—has declined; the nuclear family now accounts for a little less than 25 percent of all households. Households with single divorced members and those with no prior marital relationship have increased in number. As mentioned in Chapter 1, from a strictly economic standpoint, the single-adult-person household with or without children can be a less efficient organization than a household that has more members. The average growth of the single-adult-household category (including households with children) may be one reason that household savings in the United States has declined since peaking in 2010 after the financial crisis of 2008–2009.5

Consider the comparison of household formations in Table 4.2. In sum, we have identified a structure, the household, for individuals in their personal activities that is broadly equivalent to the structure of the business in its operating activities. Instead of having a corporation, partnership, or individual proprietorship, we have households of one person or multiple people, married or unmarried, with or without children.

Type of Household

Financial Benefits




Single person Few Can be an advantage for income taxation*

No responsibility for others

Limited to person

Married persons Specialization Economies of scale Possible reduction in risk of income fluctuation

Can be a disadvantage for income taxation

Marital responsibilities set by the government

Limited to last surviving spouse

Unmarried persons

Specialization Economies of scale Possible reduction in risk of income fluctuation

Can be an advantage over married persons for income taxation

Few legal responsibilities unless set by contract recognized by state or local municipality

Last surviving member

Each type with children

None extra Extra tax deduction— favorable tax treatment for single-adult head of household in income taxation

Additional responsibilities set by state

Last surviving adult member

* In some income circumstances, the opposite is true—for example, getting married can be less taxing than staying single.

TABLE 4.1 Household Organizational Summary

5 Organisation for Economic Co-operation and Development, Household Savings Rates, oecd-ilibrary.org/ economics/household-saving-rates-forecasts_2074384x-table 7, June 13, 2013

82 Part Two Ongoing Household Planning

This structure, which implies more logical thinking for people and shared goals for multiperson households,6 is one of the building blocks for household finance and personal financial planning theory.


Theory underlies the personal financial planning process. However, theories don’t usually completely represent how people act. In many cases, the assumptions made seem unrealistic. Theory leaves out parts of reality in order to simplify key points that will help us understand deeper aspects of behavior. Without theory, the generally recognized activi- ties of personal financial planning—cash flow and tax planning, investments, risk manage- ment, retirement and estate planning—would be thought of solely as a mechanical process. With theory, we can attempt to explain why people do what they do. Moreover, theory can enable us to think more logically and to make sound decisions, both of which can lead to higher cash flows. Let’s begin with the basic economic theory of choice and work our way to the theory of financial planning.


Household finance had its roots in economic theories. Perhaps the simplest approach is the theory of consumer choice that describes the method by which people select goods and services to satisfy their needs.

6 Martin Browning, Francois Bourguignon, and Pierre-Andre Chiappori, “Efficient Intra-Household Allocations and Distribution Factors: Implications And Identification,” Columbia University, May 8, 2008, columbia.edu/~pc2167/bbcresresubmissionpacs.pdf

Family Households


Average Size

Total Households

(in thousands)

Married Families (in thousands)

Other Families* (in thousands)

Total Nonfamily

Households (in thousands)

1950 3.37 43,554 34,075 4,763 4,716 1960 3.33 52,799 39,254 5,650 7,895 1970 3.14 63,401 44,728 6,728 11,945 1980 2.76 80,776 49,112 10,438 21,226 1990 2.63 93,347 52,317 13,774 27,257 2000 2.62 104,705 55,311 16,715 32,680 2005 2.57 113,343 57,975 18,882 36,485 2010 2.59 117,538 58,410 20,423 38,705 2011 2.58 118,682 58,036 20,578 40,069 2012 2.55 121,084 58,949 21,557 40,578 2013 2.54 122,459 59,204 21,698 41,558 2014 2.54 123,229 59,629 21,724 41,877

* Other families include male and female householders with no spouse present.

TABLE 4.2 U.S. Household Formations

Source: U.S. Census Bureau, “HH-6. Average Population per Household and Family: 1940 to Present,” www.census.gov/population/socdemo/hh-fam/hh6.xls; “HH-1. Households by Type: 1940 to Present,” www.census.gov/hhes/families/files/hh1.xls; “AVG1. Average Number of People per Household: 2014,” http://www.census.gov/hhes/ families/files/cps2014/tabAVG1.xls; “AVG1. Average Number of People per Household: 2013,” http://www.census.gov/hhes/families/files/cps2013/tabAVG1.xls; “AVG1. Average Number of People per Household: 2012,” http://www.census.gov/hhes/families/files/cps2012/tabAVG1.xls

Chapter Four Household Finance 83

Today, a great number of goods and services are offered to consumers. However, we don’t have enough resources to purchase them all. How do we decide which items to buy? The answer is that each person has certain preferences. Those preferences come from the utility—a term used in economic theory to quantify satisfaction—that an item presents. We often use two terms in connection with economics and financial matters: maximization and optimization. These terms refer to the mechanism through which individuals obtain the highest possible satisfaction from an activity. Faced with a host of preferences and limited resources, we make purchase decisions designed to maximize utility. In other words, we attempt to optimize—we try to use our resources to get the most satisfaction we can. People select goods and services from those made available in the marketplace by grouping them into consumption bundles and ranking the bundles in order of attractiveness. For example, you could oversimplify what you intend to spend money on by separating goods and services into alternative combinations of food, clothing, shelter, transportation, communication, and “fun” items. Your choice of the most attractive combination is called your consumption bundle. Attractiveness is measured by satisfaction in relation to price. Our wealth gives us the limit on the amount we can consume. This limit is called our budget constraint. We naturally select the bundle that provides us the greatest enjoyment given our budget constraint. Our selections are made not only for this year but for future periods as well. Savings allow us to consider the wide range of multiyear consumption bundles. Savings in the theory of choice represent future spending. Our choices in a more realistic multiyear time frame are made by considering all current and future consumption bundles as compared with current and future wealth.

Example 4.1 Shirley was always very serious. She came from a large family that had few resources. She was forced to go to work and set up her own household after graduating from high school. She attended college at night. While her friends spent all the money they made, she managed to put away some money for the future. Shirley had just completed a course in microeconomics and thought about her spending options in theory of choice terms. Her best friend, Jane, had an expensive apartment and loved to entertain and eat out. Most of her spare money went for those activities. Another friend, Suzanne, had a moderate rental apartment but spent all her cash left over on vacations. All three were making the same amount of income and except for the expenses noted, spent about the same amount of money. Shirley looked at Jane’s consumption bundle and found it appealing. She was also drawn to Suzanne’s interesting vacations. However, she made a decision to save 10 percent of her salary per year to ensure that later on in life she would not be placed in her parents’ weak position. She chose a modest but cozy apartment, ate out once a week, and took a moderately priced vacation each year. Given her budget constraint, she had chosen the consumption bundle that pleased her the most. In Figure 4.1 you see the differences in expenditure pattern and their utilities according to Shirley’s lifestyle preference. Be aware that utility is subjective and that as associated with similar activities will vary by person. Notice that although expenditure levels for all three friends are the same, from Shirley’s perspective, one has the best mix in her lifestyle terms. On the right-hand side of Figure 4.1, you see Shirley’s evaluation of her lifestyle and the lifestyles of her two friends.


As formulated by Franco Modigliani,7 an economics and finance professor, the life cycle theory of savings builds on the theory of choice. It shifts from the theory of choice’s hard-to-measure utility to concrete money terms. Like many economics and

7 Franco Modigliani, The Collected Papers of Franco Modigliani, vol. 2 of The Life Cycle Hypothesis of Saving (Cambridge, MA: MIT Press, 1980).

84 Part Two Ongoing Household Planning

finance theories, the life cycle theory assumes that utility can be measured in money terms. It also presents a specific theory about how people actually make decisions. It says that our spending decisions are based not on the amount of income we currently earn but on the total amount we expect to earn over our life cycle. According to this theory, once we have established our lifetime resources, we try to maintain a constant









Jane’s Outlays

Suzanne’s Outlays

Shirley’s Outlays

Shirley’s Satisfaction with Jane’s


Shirley’s Satisfaction

with Suzanne’s Lifestyle

Shirley’s Satisfaction with Own Lifestyle

C on

su m

pt io


Rest Eating Out Vacation All Other Savings Utility

FIGURE 4.1 Expenditures and Utility

The pure life cycle approach has many shortcom- ings. It doesn’t provide for money to be left for nonhousehold members such as adult children. It assumes that expenditures can remain level throughout a person’s life when, in reality, age- specific expenses such as educational outlays for children and high medical outlays for people who are elderly make that extremely difficult. Moreover, this approach doesn’t account for uncertainty in projecting future incomes and expenses and the desire of some to have a standard of living that varies by age instead of being level throughout our lifetimes. In addition, many young people can’t borrow enough money to achieve their preferred level standard of living. Why then do we study a life cycle model? First, it may be the foremost specific economic model taught that shows how people behave. Perhaps more importantly, it serves as a formative model for personal financial planning. Financial plan- ners encourage people to think beyond their cur- rent incomes and to set goals for the future.

Often these goals include an increase in standard of living for young people as their incomes rise and, as the model indicates, maintenance of a level standard of living through middle age and perhaps retirement. Planners try to take uncer- tainty into account by being conservative in their projections about returns and providing for emergency funds. Their projections of future needs can fairly easily accommodate age-specific and other “bumpy expenditures” and a sum left to others at death. On an individual basis, it doesn’t matter to plan- ners whether people desire a level, increasing, or decreasing standard of living. Planning can handle it. Planners also know that in their deliberations, people vary in the weight they place on current income and expenses versus projections for these items over their life cycle. Nonetheless, the life cycle model, with its stress on forward thinking and planning based on it, is a highly useful guide to the way many people do, and perhaps more people should, act.

Practical Comment Life Cycle Approach Evaluated

Chapter Four Household Finance 85


Amount of


Beginning of household


Household debt Savings Household assets line

Consumption expenditures line

FIGURE 4.2 Demonstration of Life Cycle Theory

level of expenditures throughout our life cycle. In other words, we try to maintain the same standard of living over our lives. The life cycle approach has great significance for households. It says that we are not impulsive consumers who spend all the money that we generate. Instead, we are planners whose actions extend beyond our current resources and pleasurable activities to our future needs and assets. The simple form of the theory assumes, as does the theory of choice, that risk and inflation are not present and that people act logically to pursue their goals. According to life cycle theory, borrowing generally takes place early in the household’s life when income is low. In that way, people can raise their consumption expenses and then attempt to even them out over their lives. Then, as the income rises, people pay off their debt and save for retirement. In retirement, when work-related revenues have stopped, sav- ings are steadily liquidated to maintain the people’s cost of living. At death there are no assets remaining. In essence, the goal is to “die broke.” The life cycle theory is illustrated in Figure 4.2. The formula for calculating the life cycle model is provided in Appendix III.


It may seem strange to read a brief discussion of business in the middle of a chapter about the household, but, as we’ve said, we will soon be looking at some of the many ways in which household and business activities are related. According to the economic theory of the firm, the firm or business is an organization that produces goods or services. It purchases inputs—raw materials, labor, and capital in their respective markets—to produce its offerings. The goods it offers are sold to households or other businesses at a price established in the marketplace outside its control. Therefore, the business concentrates on production revenues and costs It does so to find the optimum level of production that provides the highest profits. Maximization of profits, then, is the firm’s goal. It achieves its goal by making intel- ligent decisions on its use of its funds for the basic materials needed during production and in its mix of production investments. Its workers, including top management, help make those daily operating and investment decisions. Its operating costs are separated into those that are fixed and those that vary with the level of production. Profits are

86 Part Two Ongoing Household Planning

revenues minus fixed and variable costs, which can be called nondiscretionary and discretionary expenses. Remember this broad model as we begin to examine house- hold operations.


The theory of the firm describes choices in monetary terms. Gary Becker, an economics professor,8 employed a monetary framework to develop a theory of the cost of time. Households and the people living and working in them are limited, as we have seen, in the amount of money they can spend. People also are limited in the time they have available. As we all know, there are only 24 hours in a day. Fundamentally, our time can be viewed as being spent either in work-related or leisure activities. How do we decide how much time to devote to each? We compare the utility we receive from leisure time with that from the money we receive from work time. The fewer leisure hours, the greater their pleasure per hour; the higher the wage rate, the more enticing further work time is because it can purchase additional goods and services that we enjoy. Obviously, the preference for work over leisure or vice versa at any level varies from one person to another. (For a further explanation of leisure, see Appendixes I and II.) Of course, not all work is for pay. For example, we work around the house cleaning and we allocate time to get to work. Neither pays us any money, but we must perform these activities. We perform other activities, or work-related tasks, because they can be viewed as making us fit for work. When we engage in any activities that don’t provide us money, we can say we have an opportunity cost of time, Opportunity cost can be defined as a comparison and a calculation in money terms of the difference between a current use from an item and the alternative use.9 Normally, this cost of time would be our hourly wage or its equivalent.10 By placing a monetary value on our nonearning time, we can better evaluate efficiencies in many areas. For example, it can help us in making decisions about working at home by doing housework ourselves versus working longer hours for pay and hiring someone else to perform certain household duties. Or it can simply help us recognize that our leisure time is valuable and measurable.

Example 4.2 John, who earned $25 per hour after deducting tax and transportation expenses, worked four 8-hour days instead of five. He chose to bicycle through the countryside on Fridays. His cost of time for the fifth day was $200 ($25 per hour 8 hours). Clearly, the pleasure from bicycling exceeded that wage rate or he would have worked that fifth day.


We can now begin to put these economic theories to use. According to traditional economic theory, the household is merely a supplier of labor to business and a purchaser of its goods. But it is more than that: in fact, in many ways, the household resembles a small business. The household produces goods and services for its own consumption.11 It does this by combining items purchased with the time it takes to process them. For example, it

8 Gary Becker, “A Theory of Allocation of Time,” Economic Journal 75, no. 299 (1965),: 493–517. 9 The opportunity cost of time can be extended as well to not working at the maximum level of income. 10 Becker, “A Theory of Allocation of Time.” 11 William A. Lord, Household Dynamics: Economic Growth and Policy (New York: Oxford University Press, 2002), p. 286.

Chapter Four Household Finance 87

“ manufactures” cooked food to consume by combining raw materials bought at the super- market, an oven, and the production time spent preparing and cooking that food. The household product manufactured is the meal to be eaten.12 The cost is that of items pur- chased plus the opportunity cost of the time. We can extend the classical household production approach to include those items created for consumption by others. We combine business-related costs such as that of busi- ness attire with long-lasting capital goods expenditures, such as an automobile to transport us to a destination with our time at work. The resulting product manufactured, our services, is sold in the marketplace for a salary or hourly fee. In fact, the household can be viewed as producing goods and services 24 hours a day. Some add directly to revenues. Others support revenues if only by keeping us healthy and ready to provide our best during the time we allocate to work. The rest of our time and money is devoted to activities that we enjoy doing. The structure we are describing can be called the household enterprise. An enter- prise can be defined as an entity that engages in certain tasks for an end result. When people refer to an enterprise, they often think of a business, which is organized to handle a specific task—to make as much money as possible for its owners. The household enter- prise attempts to run the household as efficiently as possible in order to provide as much time and money as possible for pleasurable activities. The broader form of household production is presented in Figure 4.3.


Thus far we have dealt primarily with economics. That is because, in the past, economics has been the principal provider of broad-based information about household resources. Historically, the information was descriptive, a series of recipes for good household practices, sometimes called home economics. Becker’s work in the 1960s made home economics more scientific by introducing the cost of time and household production for internal use.13

12 Becker calls these products commodities. 13 Becker, “A Theory of Allocation of Time.”

Purchase of goods and services

Time on individual


Production of Household Commodities

Sold in marketplace

Consumed internally

FIGURE 4.3 Household Production: Establishment of Household Goods and Services

88 Part Two Ongoing Household Planning

Finance has lagged behind economics in this area. There is no integrated theory of household finance or personal financial planning. Most work in finance has concentrated on marketable securities, such as stocks and bonds, and on research on businesses and financial markets. This book sets forth an integrated theory of personal financial planning. We actually started the process by presenting the household as a leisure-seeking enterprise. In estab- lishing this theory, we view items in a financial rather than an economic framework. Although the line between the two can sometimes be blurred,14 finance places more or exclusive emphasis, relative to economics, on the following four factors that are relevant to our discussion:

• Practicality. Finance places more stress on practicality in its analysis.

• Cash flow. Finance describes most processes in tangible money terms.

• Portfolio solution. A portfolio is a grouping of assets. Finance is able to look at how those assets interact so as to provide an integrated solution to a problem.

• Risk-return analysis. Finance more often incorporates risk in decision making and can offer outcomes in combined risk-return terms.

We start by expressing the household in financial terms. Given finance’s emphasis on cash flow and the cost of time not being an actual cash charge, we reserve its use in the book for relevant decision making.


Household finance is the financial counterpart of the household enterprise. It can be viewed as personal finance placed in an organizational framework. The household is the structure that reflects all the financial activities of its members. Financial planners know this to be true from experience because financial advice is not usually requested on a person-by-person basis. Instead, personal financial planning is typically performed on an overall household basis. The goal of household finance is to have the cash flows of the household’s members managed as efficiently as possible given the household’s financial and nonfinancial objectives. In our suggested theory of household finance, a household has three types of day-to-day financial activities: revenue production, overhead costs, and leisure outlays. The most common revenue-producing activities are jobs and investment income. Overhead costs, which we can call maintenance costs, include those that directly support employment such as commuting costs and business lunches; housing support costs such as mortgage interest and utility expenses; and personal support costs such as food, nonbusiness cloth- ing, and personal care. They can be perceived as fixed costs, at least over the short term. Leisure outlays are defined broadly to include all nonwork, nonoverhead-related items. These may include eating out, watching television, playing tennis, and even shopping if the shopping is not for necessities. According to classical economic theory, all consumption expenditures are generally grouped together. In household finance, however, we can separate them more precisely. We particularly want to distinguish between maintenance and leisure costs. It is fairly easy to differentiate between them, at least for simple items. Maintenance costs are made for necessities. Leisure items provide us with utility, which, as we noted, is another word for satisfaction.

14 This especially concerns finance and financial economics.

Chapter Four Household Finance 89

Given our financial orientation, this distinction is important. We want to spend as little time and money as possible on overhead-related items. Few people get pleasure from washing the dishes. As far as most of us are concerned, the more time and money we can spend on leisure activities, the better. Of course, the choices of types of activities and whether they are time or money intensive varies by person.15

The remaining household activities are not day-to-day ones. They include capital expenditures, other types of investments, and debt financing. Capital expenditures are cash outflows that provide household operating benefits over an extended period of time. A washing machine and a car are two examples. We want to separate capital expenditures because including these often expensive cash outflows with daily costs can distort our analysis of the financial performance for the year. Additionally, merging them could result in failing to recognize the extended-period worth of the purchases for our household. Because they have ongoing worth, capital expenditures are a form of investment. Other investments, most commonly financial investments such as stocks and bonds, also are treated separately. Borrowing money or paying it off also can distort financial performance if we don’t segregate it. It is of little use to say you have $5,000 more cash in the bank this year than last if you haven’t paid attention to the fact that your credit card debt is up by $7,000 during that period. The balance of your funds is those not being used or planned for use in current operations. This free cash flow can be saved and invested for future purposes and is often where investments in stocks and bonds are placed.


By now, those who are familiar with businesses will recognize that the household is managed in many ways like a business and that household finance is similar to business finance. Both have revenues and operating expenses. Both have assets and make capital expenditures that help improve operations. Each has a goal. The goal of  a business is to earn as much profit as it can.16 The goal of a household is to maximize utility. Much is made of the difference between household and business goals. Many people would object to limiting household goals to the business goal of making the most amount of money possible. Yet, few would disagree with the view that money is one of the sig- nificant factors in achieving personal goals. The relative importance of money, of course, varies by household. Our approach—segregating daily outflows into maintenance and leisure expenditures— can help to identify the similarities between a household and a business. As we have seen, maintenance expenditures are household overhead expenses and are equivalent to business operating expenses. The household’s resemblance to a business can extend to profits and dividends. Business profits paid out to owners for their choice of use are called dividends. Household cash flows after overhead charges are the equivalent of business profits. The amounts of these cash flows paid out to household members to be used in any way they wish resemble business dividends. You can think of leisure outlays as dividends for our efforts.

15 Sometimes there is more than one reason for purchasing an item. This topic is discussed in Chapter 8. 16 Or, more precisely, to maximize shareholder’s equity, particularly in the case of a publicly owned company.

90 Part Two Ongoing Household Planning

* Net of addition to or repayments of debt and, in the case of Business, any additional equity financing as well.

Household Finance



+ +



Business Finance

Revenues from work-related output reflected in salary and pension + Investment returns

Revenues from output of goods and services + Investment returns

Nondiscretionary expense Fixed and variable cost

ProfitsProfits–Amount available for current and future needs

Savings reserved for future use Reinvested earnings intended to help generate future dividends

Cash to be distributed currently to stockholders for their use

Cash to be distributed currently to member-owners for their use for pleasurable activities

Cash flow after maintenance


Cash flow from operations

Additions to investments*

Additions to investments*

Leisure outlays Dividends

Income Income

Expense Expense

FIGURE 4.4 Household versus Business Financial Process

Viewing the household as a business implies that its activities are more complex and its decisions more logical than many people acknowledge. It is true that instead of making a correct financial decision, people may make it emotionally. But so do busi- nesspeople. Nor can one or two household members bring the same depth of knowl- edge to a topic that a specialist at a large corporation can. Household members are largely generalists. As we shall see, however, household members often make the right choice. They have an advantage over many businesses because they are able to make a decision quickly and integrate all relevant facts, which a complex organization may find dif- ficult. This ability of the household’s “owners” to make decisions rapidly without going through various levels of management and employees improves their ability to use an overall portfolio decision-making approach. This approach is explained later in this chapter. Our use of sophisticated business techniques that help with measurement can assist the household in making more logical and better-informed decisions. The similarities between the household and a business are shown in Figure 4.4. The household’s activities can be viewed a divisions as described in Appendix IV.

Chapter Four Household Finance 91

It is important to recognize that households, like businesses, have great incentives to operate effi- ciently. The more productively household mem- bers utilize revenues and maintenance expenses, the more money and time they have to participate in discretionary activities they enjoy. Interestingly, this is true regardless of members’ own value sys- tem about how many hours they work and whether they prefer active leisure or just reading a novel. Nor does an emphasis on efficiency neces- sarily detract from the pursuit of nonfinancial

objectives. In fact, it could enhance the ability to achieve them.17

17 A difference between a household and a business is that the household supervises leisure outlays whereas business responsibility stops with the payment of dividends. Given its supervision of leisure outlays, household operations could be said to have a pure business side and a personal side. The words pure business are sometimes used because, even in its leisure activities, the household can benefit from business practices such as purchasing leisure equipment at the lowest possible cost.

Practical Comment Incentive to Operate Efficiently


Modern portfolio theory (MPT) has a key place in personal financial planning. MPT, as introduced by Harry Markowitz, a finance professor, helped turn corporate finance and investments from mere words into an operating theory.18 As is true of many theories, it has proponents and critics that can point to real-life inconsistencies. We give three key principles of the theory here. The first is that investments should be viewed as part of a portfolio, not individually. What counts is how the pieces fit together. Second, in making a decision about whether to purchase an investment, don’t analyze return alone; analyze return in relation to risk. According to MPT, the higher the risk, the higher the potential return. A third principle of MPT is that overall risk is influenced by the degree of diversifica- tion among assets in the portfolio. The more dissimilar the assets are—that is, the lower the correlation among them—the lower the risk for the portfolio. For example, McDonald’s and Microsoft, when combined in a portfolio, will provide greater diversification than a combination of Ford and General Motors. These principles and their relationship to per- sonal financial management are discussed at great length in Chapters 10 and 16. Finally, keep in mind that MPT is generally limited to marketable financial investments such as stocks and bonds.


Having discussed existing theories and presented some new ideas, we can now put every- thing together and construct a theory of financial planning. It will be expressed as a series of statements that serve as building blocks for the theory.

1. PFP goal. Personal financial planning can have many goals, but overall its primary one is to enjoy the highest standard of living possible. This goal is equivalent to the theory of choice’s maximization of utility.

2. Life cycle approach. Life cycle theory provides an appropriate model of individual actions. It says that people plan for future events using current and future financial resources with the objective of smoothing fluctuations in their standard of living.

18 Harry Markowitz, “Portfolio Selection,” Journal of Finance 7, no. 1 (March 1952): 77–91 and Portfolio Selection—Efficient Diversification of Investments (New York: John Wiley & Sons, 1959).

92 Part Two Ongoing Household Planning

3. Household structure. The household is the appropriate structure through which to ana- lyze one or more people and their goals and operations.

4. Household enterprise. The household acts as an enterprise. It manufactures goods and services for internal and external use. Its objective is to become as efficient as possible.

5. Household finance. Household finance is the financial component of the household enterprise. It represents the structural counterpart of personal finance. Its function is to convert household efficiency into achievement of the highest cash flow possible given the time allocated to work-related activities. In performing operating tasks, the house- hold in many ways resembles a business.

6. Household portfolio approach. The household can be viewed as a portfolio, an accumu- lation of assets and liabilities. Decisions concerning these assets and liabilities are made on an integrated basis by household members. From a household finance standpoint, the household can be expressed as a portfolio that uses a modern portfolio theory approach but with a broader grouping of assets.19

7. Portfolio solution. The goal in financial terms is to manage the portfolio as productively as possible by allocating resources in the proper weighting to the most attractive invest- ments. In other words, its objective is to get the highest return for the risk the household is willing to undertake.

8. PFP goal achievement. Personal financial planning is the analysis and implementation arm of household finance. By generating the highest cash flow possible, household portfolio optimization satisfies the PFP goal of enjoying the highest attainable standard of living.

Put most simply, the theory of financial planning views the household as a financial enter- prise that uses a portfolio risk-return framework to provide solutions to financial planning goals. Using this theoretical approach transforms home economics into household finance. As previously stated, a suitable theory can lead to logical thinking, thereby creating higher cash flows. A theory is even more helpful when its approach can be applied in real- life circumstances without a large number of assumptions, simplifications, and modifica- tions. A practical approach to the theory is the subject of our next section.


Total portfolio management (TPM) is the active arm of personal financial planning the- ory. The household has many assets it can call on to help it earn money. Your financial assets such as stocks and bonds represent one category. Your earning power in your employment is another. The home of people who are owners, not renters, is a significant asset. The house- hold equipment you purchase to save time and money and to provide pleasure is another. Certain obligations are also relevant to TPM. Financial liabilities, such as mortgages and credit card debt, are the easiest to identify. We can consider maintenance a fixed- expenditure obligation because we have no choice but to satisfy this obligation. After all, if we don’t pay our utility bill, buy food, or put gasoline in our car, we don’t have the foundation to live the lifestyle we have established for ourselves. As mentioned earlier, these assets and obligations form a portfolio—our household portfolio. The returns we receive on this portfolio—our revenues less our overhead expenditures—are our “profits.” Our household financial projections of revenues and expenses are made on a longer-term basis as broadly structured by the life cycle theory.

19 Including liabilities, which in theoretical terms can be viewed as negative assets.

Chapter Four Household Finance 93

Because we can’t predict the future precisely, our projections are subject to unexpected occurrences, which we can call risk. TPM’s focus, then, is to provide the highest return possible for the household portfolio given the household’s resources and risk preferences. All household assets work together toward this goal. The TPM approach attempts to select the best mix of assets to achieve this objective. As you saw earlier, the higher the degree of diversification among assets, the lower is the household’s risk. Of course, the higher the return on the portfolio, the higher the standard of living household members can enjoy. TPM provides specific ways of solving household problems, which we present in the final part of the book. However, TPM does not depend on the validity or lack of appropri- ateness of any one practical interpretation of its principles. It is the veracity of the overall approach that counts most. The TPM approach is unique because it uses all household assets and obligations. Other fi- nancial models are generally limited to marketable financial assets alone, which may be appro- priate for their purposes. However, people think about all their assets and obligations in making important household decisions, and financial planners do so in making their recommendations.


Behavioral finance is the human side of money. Much of the information this book gives you teaches you the right way to plan. It suggests how people should act; how they actually do act can be very different, of course. For example, sound financial planning often ad- vises that you begin to save money for retirement as soon as you start working. The dollars saved then are much more “high powered” for accumulation purposes than identical amounts saved later in your life. Yet, many young people do act very differently; they postpone retirement saving, pre- ferring enjoyment today to what they perceive as a distant concern. When the decision to spend today is caused by imperfect mental processing of information and later regretted, behavioral financial planning enters into consideration. The approach of behavioral financial planning is to educate and establish practices that close the gap between actual and ideal planning, thereby bringing people closer to their own goals. More broadly speaking, behavioral financial planning can also provide insight into and help foster the achievement of nonfinancial goals. Many of the practical comments throughout this book concern behavioral issues, and in the final part, it has a separate chapter on this topic. This material is presented early in the book to familiarize you with several of its themes. They help to integrate the separate financial planning topics. The concepts presented here are a road map to understanding the rest of the book. Each chapter that follows relates its subject to overall household operations and, when appropriate, to TPM. The final section of the book integrates all the material presented, and Chapter 17 describes TPM in detail. Figure 4.5 presents a summary of personal financial planning theory. In this form, TPM is integrated into PFP theory; a few steps in the building process have been slightly modi- fied or combined. In sum, we have two approaches to PFP theory. The first approach, which uses mainte- nance and leisure, is consistent with pure financial planning theory and presents a more straightforward, logical approach to household finance. The second approach, which uses a nondiscretionary and discretionary approach, is more practical. Because this is a practical text, we generally use the nondiscretionary and discretionary approach for the balance of the book (e.g., for cash flow statements). We are careful to retain the basic thought that only certain outlays qualify as pleasure-producing ones. PFP,

94 Part Two Ongoing Household Planning

The individual’s search and decision process for consumption is based on maximizing utility over a life cycle. A financial planning approach is used for e�cient decision making.

The household is the designated organizational structure for an individual’s economic and financial actions.

The household acts as a factory producing commodities for internal use and for others.

The household performs as an enterprise much like a business enterprise with revenues and expenses. It has a goal of maximizing operating cash flows for the amount of time it allocates to work-related activities.

The household can be portrayed as a portfolio of all assets and liabilities that provide the cash inflows and outflows to operate the enterprise.

The decision process is done on a portfolio basis. The household portfolio solves for the optimal asset mix, which reflects maximum returns in relation to the risk the household is willing to take.

The total portfolio generates returns that provide the household with cash flows for its standard of living as represented by its leisure outlays.

The optimal return on the portfolio satisfies the financial planning goal of e�cient decision making and the highest standard of living possible.

Total Portfolio Management

Personal Financial Planning Goal Achievement

Household Enterprise

Theory of Choice +

Life Cycle Theory

Portfolio Returns

Household as Organization

Household Production Theory

Household Portfolio

FIGURE 4.5 Summary of Personal Financial Planning Theory

Chapter Four Household Finance 95

whose ultimate goal is maximization of utility, has an obligation to call attention to the maintenance-leisure separation so that planning can be effective. For example, a perceived need for a dependable means of transportation actually may be a cover for a pleasure- producing new car. For a further discussion of PFP theory issues, see Appendix III. For a further discussion of separating expenses into divisions see Appendix IV. In Example 4.3, a practical application of TPM is shown.

Example 4.3 Jan and Jen wanted advice on doing the best they could with their assets. They had $225,000 in stocks and $80,000 in bonds. They had a home worth $200,000 and were thinking of trad- ing up to a new one costing $350,000. Jan worked in the back office of a stock brokerage firm and earned $100,000 a year; Jen was a manager with a local real estate company and earned $75,000 a year. They had $90,000 left in mortgage debt and about $120,000 in overhead expenses. They described their tolerance for risk as aggressive. They were referred to an investment manager by a couple with whom they were close. The investment manager had performed some satisfactory investment services for the couple. The investment manager told Jan and Jen that he practiced modern portfolio theory. He took into account their tolerance for risk and entered their stocks and bonds in a portfolio model. The output was a reshaping of their stock and bond portfolio with recommendations on specific purchases and sales. The investment manager indicated that he had optimized their portfolio using the best market-based investment methods. Jan and Jen wondered why he hadn’t included their current and proposed real estate investments. They noted that they had the same mix of stocks and bonds as their friends. Although both couples had a similar overall risk tolerance, the other couple held relatively safe employment in contrast to the much riskier positions held by Jan and Jen. Then Jan and Jen went to see a financial planner whose services encompassed comprehen- sive planning and who practiced TPM. He told them he would include all their assets and major debt in his recommendations. He took into account their securities, real estate, and projected life cycle job-related income. He proposed an asset allocation and encouraged them to purchase the more expensive home because the projected returns would be favorable and would further diversify them, thereby reducing their overall risk. He provided a stock and bond breakdown and specific recommendations. The planner mentioned that his recommendations included a reduction in the allocation to stocks because Jan’s job at the stock brokerage firm could be affected by a decline in the stock market. A similar relationship between the home and Jen’s job was incorporated in calculations of the overall portfolio. The planner told them that the relationships among these

The separation of outlays into maintenance and lei- sure is important to the theory of financial planning. It closely approximates the business division of ex- penses, profits, and dividends. The goal of life cycle planning is to achieve a smooth standard of living figure that is based on leisure, not total, outlays. Use of this planning approach allows TPM to solve for leisure outlays, which, in theory, are the pure mea- sure of economic well-being. As an alternative to the separation of expendi- tures into maintenance and leisure, two other terms are commonly used in finance: nondiscretionary

and discretionary expenses. By distinguishing be- tween these two expenses, depending broadly on whether we do or don’t have control over them,20 we capture much of the essence of the original terms without the need for a stricter separation. Under this practical approach, the nondiscretion- ary and discretionary categories are both consid- ered operating costs. The idea of discretionary expenses as separate pleasure-producing items is maintained. 20 At least over the short term. Of course, we have more control over many items over the long term.

Practical Comment PFP Theory—A Practical Modification

96 Part Two Ongoing Household Planning

factors, which he called their correlations, reduced household diversification and therefore raised its risk. He explained that because of this, he had raised the bond allocation. The planner recommended a figure for overall living costs going forward based on the long-term returns on this total portfolio. His figure included portfolio risk and represented the highest possible living cost given their tolerance for risk. Jan and Jen found the planner’s approach and recommendations attractive. The advice was clearly based on their own personal characteristics. The financial planner had considered all their assets, not just stocks and bonds. They particularly appreciated that both financial plan- ning and investment management were integrated in one seamless operation. They decided to proceed with the recommendations and to use this planner for all their future work.

Back to Dan and Laura HOUSEHOLD FINANCE Dan and Laura had called and asked for an appointment. I thought to myself that previous discussions about financial planning and the form it had taken evidently had been insuffi- cient. Both still seemed to be concerned about their financial future. They wanted an in- stant solution to their problems, while I was offering a methodical financial plan. The trigger for a disagreement between them was a casual comment by a couple with whom they were friendly. The other couple had no financial concern; they just ran their house- hold like a business. Dan liked the idea of operating the household as a business and asked if it could be related to his college economic training. He vaguely remembered his economics profes- sor discussing home economics and wanted to know if financial planning could be related. Was there any theory of personal financial planning? Or was it just a series of financial facts? Laura, on the other hand, didn’t understand why her husband wanted to know all that “theoretical stuff.” Wasn’t financial planning just a straightforward process? Wasn’t the “cost of time” to which she had heard Dan repeatedly refer just theoretical jargon? After all, no money passed hands. Didn’t theory provide a mental headache without any useful result? She asked if they should just concentrate on the facts and the ways of reaching correct decisions and forget about economic principles and financial planning theory. By this time, Dan and Laura were glaring at each other. I wondered whether this fight was really about another more serious dispute they were having. Or perhaps they were just tense given their current financial difficulties. It obviously didn’t help that baby Brian cried intermittently as the discussion progressed. I decided to end the meeting and prom- ised to get back to them soon. That seemed to break the mood, and they left holding hands with Brian in a baby carrier that was attached to Dan’s shoulders.

Here’s my follow-up report: Both of you have raised interesting and important questions. Before I begin to answer them, let me say that it isn’t unusual for couples to differ in their take on planning and problems. Dan appears to approach problems conceptually. People who do this start with the broadest possible view and gradually narrow to the specifics. Laura, on the other hand, is very practical and wants to get to the solution as quickly as possible. It’s often an advan- tage to have both viewpoints when tackling a problem. Let’s start with an explanation of your friends managing their household as a business. We know that in some respects, our perception of a household is far from the image of a business. That is principally because the household represents more than just money fac- tors. For example, a multiperson household can represent affection and common interests

Chapter Four Household Finance 97

and a commitment to stay together. But, as you know, our interest is principally financial. Wherever possible, we attempt to express things in dollar terms. It should come as no sur- prise to you that even a business can extend beyond money interests. For example, workers may seek to further their interest sometimes to the detriment of the business, and some- times closely held business owners have goals other than just maximizing profits. Looking at the household as a business means treating household actions in a carefully thought-out way so that you get the “biggest bang for your buck”—in other words, trying to work hard in order to receive large wages. It means treating household internal opera- tions with thought, weighing whether to perform them yourself or to get machines or peo- ple to substitute for you. You would do so if it would free up enough valuable time for work or leisure to make it worthwhile. Keep in mind that the more the cash generated after overhead expense in the time allotted to work-related activities, the more choices you will have. It’s clear that your friends have picked up on that approach and its benefit. Dan, personal financial planning has grown out of home economics. Finance is more practical and uses more advanced analytical tools than the old home economics. There’s no established personal financial planning theory yet, but I’ll propose one. In it, all your re- sources and your risk preferences will work together in one portfolio to provide efficient decision making and the highest cash flows to achieve your goals. Of course, that is why we are doing this financial plan for you. Household finance is the term that can express your overall financial activities, and PFP is the strategic-results-oriented process to achieve them. Laura, you’re right that theory alone won’t achieve your goals. But theory can help you understand why we’re doing what we do and which tools to use to solve your problems. I agree that theory is of little use to you currently unless specific practical steps are taken that result in progress toward your objectives. I know you would prefer action, but in your case a more systematic step-by-step approach is best. The first action steps will come soon. As far as the opportunity cost of time is concerned, it is true that no money passes hands when we calculate it. However, the calculation could result in cash flow if you chose to replace your work at home with time in the workforce. The cost of time forces us to recog- nize that time has value as well, whether in work-related cash flow or leisure terms. Let me reiterate that both of your approaches to planning have merit. You’ll learn more about the process and about financial planning theory and its offshoot, TPM, as we go along. I’ll provide a recommended portfolio incorporating TPM principles at the end of the financial planning process when all separate planning activities will be integrated.

College Student Case Study and Review: Amy and John HOUSEHOLD FINANCE When John and Amy came in, I told them to put on their thinking caps because we’d be going over the theoretical underpinnings of PFP. John immediately asked, “Why should we go over this area? I thought PFP was a process with heavy number crunching. Isn’t this just a waste?” I replied that theories provide valuable insights and perspectives. No theory is exact, but they’re helpful in encouraging reasonable actions. In this session on house- hold finance, we’ll develop the broad overview of the concept from current established economic and financial theories. Let’s start with the household. As the organizing structure for the individual, couple or family, it is the equivalent of the corporation in business finance. The household can be defined as an organization of one or more people who share a dwelling, share financial obligations, and share other resources intended for the well-being of its members.

98 Part Two Ongoing Household Planning

Amy needed some clarification so she asked, “Does that mean that any two people who live together are considered part of the same household?” I replied, “No, they have to have a close relationship that involve sharing financial and other resources.” I elaborated that there were three basic types of household structures: single person, married persons, and unmarried persons. The financial benefit of a multiperson struc- ture is specialization in household duties that allows more expertise to be used in economies of scale. For example, two people might live in one apartment instead of paying two rental costs. Similarly, if a household includes two people with job-related incomes, the impact of sickness or layoffs will be reduced. There are also differences in taxation and legal responsibility in the three arrangements. To go from these house- hold structures to the discipline of household finance, it’s vital to understand several theories of consumer behavior.

The Theory of Choice Within all types of household structures, the theory of choice is perhaps the most basic way to look at consumer behavior. This theory says that individuals have different pref- erences in the bundle of goods and services they buy to satisfy their goals. One person may place more emphasis on an apartment and clothing whereas the other may get more pleasure from traveling and eating out.

The Life Cycle Theory Another vital concept, the life cycle theory of savings, underlies all personal financial planning. It indicates that people are farsighted. They establish a cost structure (quality of life) based not on their income today but on their projected life cycle income and other resources. The pure theory assumes that consumption expenditures stay flat over time. The life cycle theory clearly provides planning for a retirement during which assets are worked down; the goal is to have no assets remaining with the death of the last household member. This theory has certain weaknesses but remains the most popular economic approach to consumer spending and saving patterns being taught.

The Theory of the Firm The theory of the firm is a business theory. It indicates that the firm can be segmented into the purchases of inputs, raw materials, labor, and capital for production purchases. The goods produced are sold to the household, thereby creating revenue and profits. The firm’s goal is to maximize profits, calculated as revenues minus fixed and variable costs. Variable costs are also called nondiscretionary costs.

The Cost of Time The cost of time says that people’s alternative activities are limited by a 24-hour day. What people do with their time has value whether at the margin they decide to work or to select among different leisure time alternatives based on the pleasure each brings. Each unit of time spent is called a production activity. The value of each hour of work or leisure is mea- sured by the amount of money 1 additional hour of work would provide. Looking at it in this manner can make it easier to select between working harder or, say, having more fun eating out. The choices offered that don’t produce money directly are called the opportu- nity cost of time. Each consumer selects the optimal mix for his or her self.

The Household Enterprise Understanding these theories can help us put the theories together. The household enterprise acts like a firm by producing produces goods and services to sell to others and to consume internally. Each item can be priced separately, using the opportunity cost of time. The house- hold enterprise attempts to maximize the utility of its activities by selecting the optimal mix.

Chapter Four Household Finance 99

Household Finance We now shift to finance from what was principally an economics framework. There is no inte- grated theory of household finance, but the textbook I gave you to read sets up such a theory. Finance differs from economics in being more practical, expressing itself in money terms, hav- ing a portfolio solution (grouping of assets), and more frequently using risk–return analysis. Household finance provides a framework for looking at the household enterprise with much more emphasis on money. The household is equivalent to its structure, not the indi- viduals that comprise it. In anticipating your question, based on your quizzical nonverbal communication, yes, Amy, the individual can still be the sole owner and occupier of the household. The goal is to plan cash flows so the household operates as efficiently as possible, given both financial and nonfinancial objectives. The three types of day-to-day financial activities are revenue production; overhead costs, which are also called fixed costs or maintenance costs; and leisure outlays, which are nonover- head items. Leisure items produce pleasure whereas overhead costs, while necessary, do not. Non-daily activities are capital expenditures (which provide benefits over an extended period of time), other types of investments, and debt financing. Combining cash flow from day-to-day activities with that of non-day-to-day activities provides a free cash flow that often is placed in stocks and bonds.

The Household as a Business Both Amy and John commented that PFP theory sounded in many ways like business fi- nance. I agreed and said that the household is very much like a business. It attempts to maximize its revenues in the time devoted to it. The household tries to reduce its fixed costs because it derives no pleasure from it. It attempts to maximize its profits by optimiz- ing its leisure activities—a combination of time and cash flow to full life cycle leisure activities. One difference of the household business is that money alone is not its goal but also includes the quality of life, which differs for each household. John then joined in, saying, “We shouldn’t disparage money because for many people it leads to or importantly influences whatever goal people select.” I agreed with John’s comment.

Modern Portfolio Theory Modern portfolio theory (MPT) incorporates these three principles:

1. Looking at a portfolio as a whole, not just component by component.

2. Viewing not only return but risk as well—the higher the risk, the higher the anticipated return.

3. Addressing overall portfolio risk by diversification, which includes correlation, and is the degree to which items in the portfolio move together. All other things being equal, the lower the correlation, the lower the risk is. Unfortunately, MPT generally is used only for stock and bond analysis. We’ll return to this point soon.

The Theory of Personal Financial Planning This theory is a construction of all that we have discussed before. PFP’s goal is to enjoy the highest standard of living possible. It is equivalent to the maximization of utility in the theory of choice. PFP combines the household structure and the life cycle approach into the household enterprise. Limit it principally to monies, and you have household finance. When performing household tasks, the household operates in many ways as a business. The household is viewed as a portfolio with assets and liabilities. Decisions on adding or selling assets are made on an integrated portfolio basis. In financial terms, the portfolio solution comes from allocating the proper amount to assets and liabilities. PFP is the implementation arm of personal finance. When the proper allocation has been determined, it satisfies the PFP goal of attaining the highest standard of living possible.

100 Part Two Ongoing Household Planning

Total Portfolio Management TPM, a proprietary program, is the active arm of PFP. It incorporates in its analysis of as- sets not only stocks and bonds but also human assets (valued by bringing all future cash flows to the present), and real estate—including the home and household equipment. TPM also includes all liabilities, not just financial ones including mortgages and credit cards, but also nonfinancial ones such as the fixed costs that are required to run your household. The result is a full array of all household assets and liabilities. TPM also considers the risk preferences of the individuals, which, of course, varies by household. TPM searches for the best mix of assets that is likely to provide the highest return. The highest return on the portfolio produces the highest standard of living possible. We’ll return to TPM throughout our discussions.

Behavioral Financial Planning Behavioral finance is the human side of money. Humans make mistakes, and that ten- dency creates a gap between actual and ideal planning. Behavioral financial planning at- tempts to close that gap. It also deals with helping achieve nonfinancial goals as discussed in Chapter 3.

Summary Household finance and PFP theory reflect the basic thought that a household can be per- ceived as a business and include all resources in making its decisions. Specifically:

• The household is the organizational structure that incorporates all of a person’s or a group’s financial activities.

• The household signifies logical financial actions and, in the case of several members, it draws their personal financial planning objectives together.

• The household is a functioning enterprise. Its stress on having efficient operations and generating the highest cash flows for the time allocated to work is analogous to a business.

• Household finance is the financial counterpart of the household enterprise. It represents a person’s entire financial life. Its origins are in economics and financial concepts such as the theory of choice, life cycle theory, the cost of time, the theory of the firm, modern portfolio theory, and risk–return analysis.

• The opportunity cost of time provides a dollar amount for time spent on activities that don’t actually provide money to the household. Assigning a value to time makes it easier to include it in planning and decision making.

• The life cycle theory of savings has strongly influenced personal financial planning. It maintains that people include thinking about their future in their actions today. The strict form of the theory says that people try to even out their resources over their life- time. However, the approach can allow for more flexible interpretations.

• Household outlays can be separated into nondiscretionary and discretionary outlays. We try to minimize nondiscretionary outlays or overhead expenses. Discretionary out- lays usually provide us pleasure, and we strive to increase the money and time con- nected with them.

• PFP theory is an integrated overall approach to decision making for household finance. It uses TPM as its underpinning. TPM says that all household assets should be included in decision making. The best mix of those assets leads to the largest cash flow possible within risk and time allocated to this task. This optimal mix satisfies the personal finan- cial planning goal of achieving the highest standard of living possible.

Chapter Four Household Finance 101

Key Terms behavioral financial planning, 93 budget constraint, 83 capital expenditures, 89 consumption bundle, 83 discretionary expenses, 86 firm, 85 household, 80 household enterprise, 87

household finance, 88 leisure outlays, 88 life cycle theory, 83 maintenance costs, 88 modern portfolio theory (MPT), 91 nondiscretionary expenses, 86 opportunity cost of time, 86

overhead costs (maintenance costs), 88 theory of consumer choice, 82 total portfolio management (TPM), 92 utility, 83

1. Define the household in financial terms.

2. What makes the household the financial structure for the individual?

3. List some of the advantages and disadvantages of various organizational structures for the individual.

4. How do people choose their goods?

5. How are spending decisions made according to the life cycle theory of savings?

6. What does life cycle theory say a household should have in savings at the end of its life? Is that practical? Explain your answer.

7. Define the term opportunity cost of time.

8. The cost of time is a noncash charge, so why is it important?

9. What makes the household an enterprise?

10. How do finance and economics differ in emphasis?

11. Describe household operations according to household finance.

12. Why is it important to differentiate among the various types of household expendi- tures?

13. Outline the similarities and differences between a household and a business.

14. What is the importance of the theory of financial planning?

15. Are any of the outlays in Table 4.1 preferable to the others? Support your answer.

16. When would it be beneficial for the household enterprise to outsource some activities, for example, cooking?

17. If operating efficiently is the main goal of a household enterprise, are there any draw- backs?

18. What is TPM and why is it valuable in the framework of household planning?

19. What is to be gained by incorporating both theory and practical tools, such as oppor- tunity cost of time, into household planning?


102 Part Two Ongoing Household Planning

Case Application HOUSEHOLD FINANCE Richard and Monica asked if they could come in to discuss an issue. At that meeting, Monica seemed worried, and Richard sunk back in his chair. Monica said Richard was hav- ing second thoughts about going ahead with the financial plan. He wanted to know what the specific benefits of financial planning were. As far as he was concerned, he said, people’s planning took place one paycheck at a time. I could tell by Monica’s way of explaining this that she disagreed. She asked for my help in dealing with this problem.

Case Application Questions 1. What do you think is the difference in philosophy between the two?

2. How does the life cycle theory enter the discussion?

3. Based on the original interview with Richard and Monica and this one, how can looking at the household as a business help?

4. What are the benefits of financial planning for these people? 5. Write your explanation to their issues and your recommendation.

Appendix I

Leisure Time Our discussion of leisure time includes how we use the opportunity cost of time to measure leisure as well as how leisure-time decisions relative to work decisions are made. Doing so can help us reach better financial conclusions. First, let’s briefly review. From a classical economic standpoint, we can define leisure time activities as expenditures for goods and services that provide utility. If we consider the opportunity cost of time, we can define leisure outlays as expenditures for goods and services plus time spent on activities that provide utility. The combination of expenditures and time form a leisure commodity. For example, buying a ticket to a movie plus the time spent watching it result in a leisure commodity. So, we can think of leisure as time and money spent on things we enjoy doing. The view of leisure as a commodity that includes an opportunity cost of time has an important benefit: the ability to include all costs, not only cash expenditures, in computing leisure outlays. Having a fairly gauged standard for calculating leisure outlays allows us to place utility on a plane we can more easily understand and measure in economic and finan- cial terms. We generally cannot calculate total utility per person, but we are able to analyze mar- ginal utility at equilibrium. Marginal utility is the pleasure we get from one additional unit of an item we consume. Equilibrium is the state at which two forces—in this case utility and goods purchased—are in balance. At equilibrium, the marginal utility or plea- sure from each good or service relative to the price we pay for the good or service is equal. At the same time, the ratio of marginal utility to price for each leisure good is equal to the benefit in cash flow (to be spent on future utility) relative to the cost in displeasure

Chapter Four Household Finance 103

from one additional hour of work. In other words, if we call our benefits-to-cost ratios relative values, in equilibrium all of our marginal actions provide us equal values. If they didn’t, we would alter the selections. The equation can be expressed as

MUx Px

= MUy

Py = p =

MUn Pn


MU = Marginal utility P = Price in resources of each and time x, y, . . . n = Leisure goods

We illustrate the method of measuring leisure costs and considering those costs in affirm- ing our equilibrium analysis.

Example 4.A1.1 Jack rents a tennis court three times a week, spending $10 each time. He plays tennis for 1 hour each time. He earns $12 an hour in his job. Therefore, his cost of time is $12 for each visit. He goes to the theater once a month, which costs him $34 for each three-hour perfor- mance. Jack decides to set up a utility scale that starts at 100 units. The money he earns by working provides him 132 units of pleasure per hour. He estimates that the theater gives him 770 units of pleasure each week. In contrast, tennis gives him 242 units of pleasure each day. He wants to know whether he has a logically placed equilibrium between tennis and theater outlays and whether he should replace leisure activities with additional work.

At equilibrium:






MUTE = Marginal utility of a unit of tennis MUTH = Marginal utility of a unit of theater MUW = Marginal utility of an hour of work PTE = Cost of a unit of tennis PTH = Cost of a unit of theater PW = Cost of an hour of work


Marginal price of tennis = Cash outlays + Cost of time

= $10 + $12

= $22


Marginal utility of tennis = 242

MUTE = 242

PTE = 22




22 = 11

104 Part Two Ongoing Household Planning

Marginal price of theater = Cash outlays + Cost of time

= $34 + $36

= $70 and

Marginal utility of theater = 770

MUTH = 770

PTH = 70




70 = 11

MUW = 132

PW = 12


PW =


12 = 11

Jack spends more than 3 times as much money for the theater as for 1 game of tennis. However, the utility per unit of cost of 11 is the same for tennis and the theater. Jack has se- lected his leisure activities properly. His benefit-to-cost ratio for work is equal to that for leisure activities. He should not alter his labor-leisure ratio because he is at equilibrium. Note that any leisure item considered would have as its benchmark the comparison of the utility in earning cash from 1 more hour of work.

Our analysis can be extended so that we can compare decision making among individu- als for the same leisure opportunity. The consumption pattern of a person with a low cost of living and great satisfaction from “doing nothing” will be different from that of a person who enjoys “keeping up with the Joneses.”

Example 4.A1.2 Kate and Evelyn are computer programmers, both employed by the same company. Each earns $35 an hour and works 2,000 hours a year. Both are offered some additional work on Saturdays at $50 an hour. Kate has a modest cost of living and spends Saturdays with her fam- ily. She rejects the additional pay, even at $50 an hour, as insufficient to compensate for the pleasure of relaxation and family interaction. Therefore, her marginal utility for current leisure exceeds $50 an hour. Kate has actually requested a reduced work schedule of four-days. Evelyn, who has a high cost of living and would like to retire at age 55, accepts the Saturday offer thinking that her leisure time today is less important than the consumption of leisure time starting at age 55. Her marginal utility for current leisure is less than $50 an hour. Notice that each is optimizing her own choices or bundles of consumption commodities.

Our discussions using the cost of time have enabled us to take a seeming intangible, consumer satisfaction, and describe it in money terms. In this way, we are able to main- stream leisure into the financial decision-making process. By using dollars to describe leisure alternatives, we can accommodate virtually any lifestyle including one that empha- sizes keeping dollar earnings to a minimum. In other words, the marginal utility of leisure can help us come to better personal finan- cial planning conclusions concerning work and leisure, including which leisure activity to select. It can do so by incorporating time as well as cash outlays in the decision framework and placing a cost on each. Equilibrium analysis is provided in Appendix II. Table 4.A1.1 presents how the average man and woman spend their time.

Chapter Four Household Finance 105

Mothers Fathers

1965 2008 1965 2008

Total Paid Work 9.3 23.2 46.4 42.6 Work 8.4 21.6 42.0 39.1 Commute 0.9 1.5 4.3 3.4 Family Care 49.5 38.9 11.9 21.2 Housework 31.9 23.6 4.4 9.5 Childcare 10.2 13.9 2.5 7.0 Shopping/Services 7.4 7.1 5.1 4.8 Personal Care 74.4 74.9 74.7 71.9 Sleep 55.4 59.6 55.7 57.1 Meal 8.9 7.0 10.5 7.8 Grooming 10.1 8.2 8.5 7.0 Total Free 34.8 31.0 35 32.3 Education 0.7 2.0 1.2 1.4 Religion 1.1 1.0 1.2 0.8 Organizations 1.4 1.5 1.0 1.4 Event 1.2 0.9 0.6 0.9 Visiting 9.0 4.1 8.4 3.4 Fitness 0.6 1.2 1.3 2.1 Hobby 2.8 0.8 1.2 1.2 TV 10.3 13.5 13.4 15.4 Reading 3.4 1.5 4.2 1.2 Stereo 0.3 0.1 0.6 0.2 Communication 4.0 4.5 2.0 4.3 TOTAL TIME 168.0 168.0 168.0 168.0

TABLE 4.A1.1 Time Use Trends of Mothers and Fathers*

Source: Suzanne M. Bianchi, “Family Change and Time Allocation in American Families, Alfred P. Sloan Foundation WorkPlace Flexibility, 2010. http:// workplaceflexibility.org/images/ uploads/program_papers/ bianchi_-_family_change_and_ time_allocation_in_american_ families.pdf

Appendix II

Equilibrium Analysis: Labor and Leisure Hours The assumption of constant labor and leisure hours makes decision making for the household simpler to describe and quantify. Clearly, in a business, the goal is to earn the most money possible. We can call its objective the maximization of cash flows. The business produces and expands as much as possible as long as it is profitable to do so. Equilibrium is set, and the business stops when the revenue it makes from an extra unit of output exactly equals the cost of producing that unit. Similarly, equilibrium is set, and households want to maximize their operating cash flow given a certain amount of time devoted to work. The household stops working when the benefit it receives from an extra hour of work revenues equals the cost in forgone leisure pleasure. The difficulty is in fixing the amount of work time. For example, if a person were to receive a raise in salary, the labor-leisure ratio cannot be precisely determined. Higher pay could result in more hours worked because working more hours would increase the financial reward. Economists call that the substitution effect. Alternatively, the raise could lower the hours worked and increase leisure time because, if the same income is desired, it can now be received with less work effort. Economists call this the income effect. The household’s choice will depend on the marginal utility of work versus that for leisure, given the higher income. The process was described in Appendix I. By assuming no change in overall labor or leisure hours, we can express the outcome in exact dollars. A $10,000 increase in after-tax salary is equal to a $10,000 rise in cash flow from operations. A fixed labor–leisure ratio highlights internal household operations. It suggests a focus on making the household operate as efficiently as possible.

* Hours per week.

106 Part Two Ongoing Household Planning

Many people work in one job in which their salary and work hours are determined. The emphasis then is entirely on household efficiency. The focus is similar to the business fo- cus on efficient operations. Think of it as an eyewear store in a shopping mall in which the prices of a visit and a pair of glasses are set by the market. By mall contract, the store can stay open only for 12 hours a day, and it is currently at capacity—that is, the store is unable to accept more than its current volume of clients each day. Therefore, the store can gener- ate higher cash flows only by becoming more efficient in its operations. As a practical matter, although the fixed labor–leisure assumption makes outcomes clearer to measure, the assumption is not necessary. The point is that the household will attempt to operate as efficiently as possible and maximize its operating cash flows both before and after a change in incomes and at whatever labor-leisure ratio it establishes.

Appendix III

The Life Cycle Theory of Savings The classical approach to savings comes from Modigliani in his Life Cycle Theory of Savings.21 As we saw, consumption decisions for Modigliani are based not on the amount of income we generate currently but on the amount of income we expect to earn over our life cycle. Household income may fluctuate from year to year, but we seek to maintain a constant standard of living throughout our lifetime. According to this theory, the value of all household assets is assessed at a given point in time. Assets are separated into work-related and other assets. The stream of work-related income is brought back to the present using a market-provided discount rate to establish an asset value. Other assets, assumed to be marketable assets that are owned by the house- hold, also are evaluated. We then plan to consume the income and principal from those assets in a way that will result in level expenditures over our lifetime. Given the desire for level expenditures over our life cycle, we might create negative savings in life by borrowing money when income is low; then, as our income rises, pay off the debt and save for retirement. In retirement, when our work-related revenues have stopped, we would liquidate savings steadily to maintain our cost of living. At death no assets would remain. The implication is that a change in one year’s income—for example, a large bonus received—will not alter our spending habits. Spending patterns will be changed only by a permanent shift in expectations of future income. The Modigliani life cycle formula is

c = y + 1N − t2 × ye + a


Current Expected Current Projected Current

income +

a retirement age

– age

b ×

yearly income +


Remaining life span Current consumption


21 Franco Modigliani and Richard Brumberg, “Utility Analysis and the Consumption Function: An Interpretation of the Cross Section Data, ” in Post-Keynesian Economics, ed. K. Kurihara (New Brunswick, NJ: Rutgers University Press, 1954); Franco Modigliani and Richard Brumberg, “Utility Analysis and Aggregate Consumption Function: An Attempt at Integration,” in The Collected Papers of Franco Modigliani, Vol. 2, ed. A. Abel and S. Johnson (Cambridge, MA: MIT Press, 1980). For a variant on the theory, called “the permanent income hypothesis,” see Milton Friedman, A Theory of the Consumption Function (Princeton, NJ: Princeton University Press, 1957).

Chapter Four Household Finance 107


c = Current consumption

y = Current income

a = Current assets

t = Current age of the household

ye = Projected yearly income

N = Expected retirement age

(N − t) = Expected remaining earning span in years

L = The life span

The formula indicates that consumption is developed by taking current income y, plus the value of total future income (N − t) × ye, plus the value of current assets a, and dividing the sum of the three by the remaining life span in years. Put more simply

Current consumption = Current income + Projected future income + Current assets

Remaining life span

By dividing all our income and assets by the number of years we have remaining, we arrive at the maximum consumption we can afford. This model assumes that we know many variables, such as the date of death with certainty. The critical underlying assump- tion of the model—that consumption today is not related to current but projected future life cycle income—is illustrated in Example 4.A3.1.

Example 4.A3.1 Jamie, 35, worked as a medical resident for Techno Corporation. She made $45,000 a year but knew that she would make $90,000 a year in real terms starting next year and there- after as a full-fledged physician; she had $255,000 in assets accumulated today. Assume that Jamie knew she would work until age 65 and die at age 84 and that the discount rate was equal to the growth rate in future salary. Therefore, her salary can be considered flat over time. Assume that Jamie would not be eligible for Social Security benefits. What will her cost of living be?

c = y + 1N − t2 × ye + a


= 45,000 + 165 − 352 × 90,000 + 255,000

84 − 35 + 1

= 45,000 + 30 × 90,000 + 255,000


= 3,000,000


= $60,000 per year

Notice that her cost of living does not significantly depend on her current salary; it is related to her current assets and projected lifetime income. Jamie’s cost of living throughout her life- time must be adjusted to plan for 20 years of expected retirement with no income at retire- ment time other than the amount accumulated from prior investments.

108 Part Two Ongoing Household Planning

Appendix IV

Divisions As you have seen, household operations consist of the generation of revenues, the payment for household expenses supporting revenues that include basic human needs, and the out- lays of time and money on pleasurable activities. We can call them divisions. The first one can be termed the production division. It produces the resources the household needs to sustain itself and includes the expenses that support it. The second can be termed the dis- tribution division. It spends resources on things that we enjoy doing. This setup is not unlike a business that has multiple divisions. Its use can provide information on the idea of the leisure dividend. Like a business, the household can declare a dividend. However, business operations stop with the payment of the divi- dends. The household’s activities are broader and include decision making on how to spend the dividend. The household enterprise uses business techniques in both production and distribution activities. Both need to be as efficient as possible in pursuing their objective. Money gen- erated from the production division not reserved for future use is paid to the distribution division in the form of a cash outflow, a dividend. The distribution division records this money as revenue available to spend. When the two divisions are consolidated, the produc- tion outflow and the distribution inflow drop out. On a total household basis, we are left with revenues less overhead costs from the production division and outflows on leisure activities from the distribution division. In common financial parlance, broadly speaking, overhead costs and leisure outlays are called nondiscretionary and discretionary expenses. We generally use that terminology throughout the book. However, we retain the idea of a dividend. It helps focus on the difference between the two types of expenses, one for a necessity and the other for a pleasurable activity. The leisure dividend is far different from a maintenance cost. That is why in this book we have generally called leisure an outlay instead of an expense.


Chapter Goals

This chapter will enable you to:

• Recognize the importance of financial statements to PFP.

• Produce and evaluate a balance sheet.

• Construct a cash flow statement.

• Compare finance and accounting-based techniques.

Laura had dropped in alone one afternoon seeking an explanation of financial statements. She felt a little lost during conversations about financial statements with their friends and was looking to become more aware about balance sheets, cash flow statements, and so on.

Real-Life Planning

Todd and Julia were a young couple whose lifestyle was on a fast track. Todd was a lawyer with a nonprofit company and enjoyed his work for it. Julia was a writer whose novels were only modestly successful. They entertained lavishly and were known in their small town for the parties they had. Neither Todd nor Julia had large work-related incomes. Julia’s parents had both passed away at an early age and had left her a significant inheritance. When the advisor inter- viewed them, it became apparent that they had no idea about their finances. When asked about their yearly savings, they said they were strong savers but didn’t know the amount. Then they mentioned that they had a home equity loan and borrowed money and paid off debt all the time; sometimes they sold some of the securities from Julia’s inheritance to pay off some debt. They wanted to do even more entertaining and asked how much they could afford. The advisor decided to begin by constructing a balance sheet and cash flow statement. The balance sheet showed that they had assets that chiefly consisted of a house worth $400,000 and securities from the inheritance amounting to $250,000. They had no idea what the market value of these securities was. The advisor asked the amount of the original inheritance and found out it had been $450,000. The decline in investment assets despite a favorable stock market was surprising, and the advisor made a mental note to use it as a check against the results of the cash flow statement. However, nothing prepared him for the $410,000 combined mortgage and home

Chapter Five

Financial Statements Analysis

110 Part Two Ongoing Household Planning

equity loan on the house. Because the home was worth $400,000 in effect, the couple had no equity in it even though their original mortgage was for much less. The only reason the home equity line was extended for so much money was that Julia’s assets were pledged as collateral against the loan. The cash flow statement disclosed a large negative cash flow each year. The couple made up the negative cash outflow from operations through both additional borrowing and liquidating securities. The advisor showed them the balance sheet and cash flow statement. The balance sheet indicated what their assets, liabilities, and net worth were now as compared with two years ago. It confirmed that their assets had declined and their obligations were higher now. Julia mentioned that their net cash flow had been positive in recent years. She asked, “Why the concern?” The advisor explained that the only reason for the positive amounts was the combination of asset liquidation and increased borrowing. Their true operating figures a few lines up on the cash flow statement showed large deficits. If they continued the way they were going, they would run out of money before too long. Both Todd and Julia were visibly shaken. Todd mumbled that he had no idea things were so bad. The advisor wasn’t surprised. In his experience, many people were finan- cially unsophisticated and didn’t even know the purpose of a balance sheet and cash flow statement. He wondered what percentage balanced their checkbooks. The advisor spent some time educating them in basic finance, presented options, and recommended that they be placed on a budget. They said little and left. Three weeks later, all three sat down again. Todd and Julia said that their plans for future parties would be scaled down sharply. Todd was looking for a new position with a law firm that would pay considerably more money. Not so surprisingly, they wouldn’t adhere to a detailed budget but agreed to hard figures for debt reduction and cash savings. They called it their “financial diet.” They scheduled the next meeting, and the advisor noted they had their old enthusiasm back. When given some financial knowledge, in part through examining financial statements and keeping to a financial regimen, even a loosely structured one, positive things could happen.


Financial statement analysis is a key part of the planning process. Our objective often is to make a preliminary assessment of the financial health of the household early in the data- gathering process. With some experience, we may be able to obtain a rough indication of assets and liabilities accumulated. We should then draw up an accurate balance sheet as part of the planning process. The second financial statement we are usually interested in is the one that presents the household’s cash flow. Cash flow is at the heart of PFP. It is difficult for many to balance current living needs and preferences with savings. The cash flow statement tells you how you are doing today and sets the stage for any steps that need be taken to alter future activities. A projected cash flow statement can provide further structure and insight. This chapter shows you how to construct both statements and discusses related issues.


The balance sheet is a statement of financial position at a given point in time. When describing personal statements, it is often referred to as the statement of financial position. It consists of all your assets, your liabilities, and your net worth. The first assets listed are generally cur- rent assets. Current assets are those that are expected to be or can be converted into cash in

Chapter Five Financial Statements Analysis 111

the current year. They include checking accounts, money market funds, and refunds due such as those on catalog purchases. Marketable investments are those that are traded publicly— for example, stocks and bonds. Retirement investments that are not available for current use are treated separately. Real estate typically refers to the home; household assets—a vehicle, furniture, and appliances, for example—are those used in day-to-day household activities. Other assets are a miscellaneous category that can include such things as jewelry and art. The most prominent asset for the household is typically the future income stream of its wage earners, called human assets. Because they cannot be sold, however, human assets are not usually placed on balance sheets. Human-related assets is a broader term that includes other forms of resources in addition to human assets that are omitted from the bal- ance sheet. The term human-related is used because the value is derived from human-related work efforts or human relationships. Included are pension plans that pay out yearly income upon retirement such as Social Security or company pensions. Expected gifts and inheri- tances based on relationships are other examples. Liabilities are items the household owes. They are placed on the right-hand side of the bal- ance sheet. Credit card debts, taxes outstanding, and mortgage debt are all liabilities. They too can be separated into current and long term based on whether they are due within one year or beyond that period. The mortgage payment due within the year is expressed as a current liability. Household equity, another name for household net worth, is the difference be- tween its assets and liabilities. It is intended to show how much the household is worth at that point in time. Household equity can be relatively small or even negative when house- hold members are young and college debt and other obligations are high. Net worth gener- ally increases as the marketable investment portion rises. The process of generating net worth is shown in the simple Example 5.1.

Example 5.1 Tricia had a $20,000 savings account, owned a car valued at $12,000, and owed $9,000 that she had borrowed to help finance the car. Calculate her net worth and explain the process.

Assets $32,000

Liabilities (9,000)

Net worth $23,000

Although Tricia has assets of $32,000, there are $9,000 of obligations against those assets. Consequently, her net worth, the equity she has built up over time, is $23,000.

The balance sheet has many formats. A common one is shown in Table 5.1. Example 5.2 uses that balance sheet.

Example 5.2 Shirley had $500 in cash, $12,500 in stocks, and $2,500 in bonds as well as a car worth $12,000. She had debt of $2,000 in credit card payments, an education loan of $8,000 with payments not due to begin for three years, and a mortgage loan of $144,000 with $5,000 due this year. She owned a home worth $175,000, furniture and fixtures of $3,000, appliances with a value of $4,000, and jewelry of $5,000. She expects to pay her mortgage and other obligations from current year’s earnings. Her balance sheet follows.


Household Balance Sheet 12/31/15

Assets Liabilities

Current Assets Current Liabilities Cash $500 Credit card payment $2,000 Total Current Assets $500 Current portion mortgage loan $5,000 Total Current Liabilities $7,000

112 Part Two Ongoing Household Planning

A summary and explanation of balance sheet items appears in Table 5.2.

Marketable Investments Bonds and bond funds $2,500 Long-Term Liabilities Stocks and stock funds $12,500 Mortgage loan $139,000 Total Marketable Investments $15,000 Education loan $8,000 Total Long-Term Liabilities $147,000

Real Estate Home $175,000 Total Real Estate $175,000 Total Liabilities $154,000

Household Assets Autos $12,000 Furniture and fixtures $3,000 Appliances $4,000 Total Household Assets $19,000 EQUITY

Other Assets Jewelry $5,000 Household equity $60,500 Total Other Assets $5,000 Total Equity $60,500 Total Assets $214,500 Total Liabilities and Equity $214,500

Household Balance Sheet 12/31/15

Assets Liabilities


TABLE 5.1 Household Balance Sheet 12/31/15

Assets Liabilities

Current Assets Current Liabilities Checking accounts Credit card debt Money market funds Other current debt Refund due on returned clothing Current portion

Total Current Assets Total Current Liabilities

Marketable Investments Long-Term Liabilities Bonds and bond funds Mortgage Stocks and stock funds Other long-term debt

Total Marketable Investments Total Long-Term Liabilities

Pension Assets Total Liabilities 401(k) plans IRAs

Total Pension Assets

Real Estate Home

Total Real Estate

Household Assets Vehicles Furniture and fixtures

Total Household Assets

Other Assets EQUITY Jewelry Stamp collection Household equity

Total Other Assets Total Equity

Total Assets Total Liabilities and Equity

Chapter Five Financial Statements Analysis 113


The cash flow statement is perhaps the single best measurement of the financial perfor- mance and therefore the health of a household. This is so because it represents how much cash has been generated over a period of time. When describing personal statements, it is sometimes referred to as the statement of cash flow. All household operations that re- quire financial resources are included. The word flow indicates that it measures results between two periods, say between the end of last year and the end of this year. The cash flow approach contrasts with that of the balance sheet, which provides figures as of a specific time—for example, as of the end of this year. The amount of water in a pond is constant at any point in time like a balance sheet, whereas a stream has water enter- ing and leaving like a cash flow statement with change measured by the strength of its flow from the beginning to the end of the period. The cash flow statement is fairly simple to understand and measure. Your cash gener- ated is the difference between the cash you started and ended the period with. As you might expect, it is determined by totaling the sources of cash—your cash inflows—and subtracting from it the uses of cash—your cash outflows. For example, revenues you re- ceive from your job are a source of cash whereas rent you have paid would result in an outflow of cash. Under our household finance approach, which entails running the household as a busi- ness, we can benefit from a detailed cash flow statement. We can call that document a functional cash flow statement. This functional statement separates cash flows by type of household activity into basically three types: operating, financing, and investment ac- tivities. Investments are separated into capital expenditures, which are shown separately, and financial investments, which are grouped last with remaining cash flows, which are our savings for the period. Use of a functional cash flow statement permits a clearer description of household re- sults for the period and an easier comparison with other periods. It is structured as a blend of the business income statement and its cash flow statements.

TABLE 5.2 Balance Sheet Items Explanation

Category Definition Examples


Current assets Those intended to be liquidated within the year. Checking accounts, tax refunds, merchandise refunds not yet received. Marketable investments Financial assets that can be turned into cash. Stocks, bonds, mutual funds. Retirement investments Financial assets in individual or company plans. Stocks, bonds, mutual funds. Real estate Property attached to land. Generally, the land and Home, investments in other property. property on it are given a combined valuation. Household assets Assets used in household operations. Car, furniture, household, appliances. Other assets A miscellaneous category. Jewelry, stamp collection, etc.

Liabilities Current liabilities Those expected to be paid within the current year. Those expected to be paid currently, taxes due, current portion of mortgage on house. Long-term liabilities Due beyond the current year. When there are few, they Mortgage, home equity loan, may be clustered together. long-term credit card debt, amounts owed to parents.

Equity Total equity Generally a one-line category representing net worth. Combined assets less combined liabilities.

114 Part Two Ongoing Household Planning

Example 5.3 To see the difference between traditional and functional cash flow statements, consider Caitlin, who funnels all of her financial transactions in and out of her checking account. Her salary goes in there; the same is true of any bonus, birthday or holiday gifts, refunds, insurance payouts, and so on. Caitlin pays all of her bills from this checking account by writing checks, arranging for autopay, or using her debit card. If she needs to draw on her savings, she’ll trans- fer an amount from her money market fund or her brokerage account to her checking account. She’ll withdraw pocket money from that checking account via an ATM. Thus, month-to-month or year-to-year activity in that checking account serves as Caitlin’s cash flow statement for that month or those 12 months. If she has $12,000 in the account on January 1 of one year and $16,000 in that account on January 1 of the next year, Caitlin’s traditional cash flow statement shows that she had $4,000 of positive cash flow. If the balance had fallen to $10,000, Caitlin would have had $2,000 of negative cash flow. Now, such a process is certainly simple and hassle free, but for financial planning, it leaves unknown a lot of desired information. Caitlin may think she’s doing fine with a $4,000 positive cash flow even while she’s drawing down her savings, just as we saw with Todd and Julia ear- lier in the Real-Life Planning section in this chapter. Caitlin’s financial picture would be clearer if she used a functional cash flow statement instead. She could still keep things simple, as described, but she also would keep track of cer- tain types of inflows and outflows. Those would be financing (increases or decreases in her debt levels) and investments (purchases of long-lived assets, home improvements, increases or decreases in her personal savings). Removing financing and investing activity from her net cash flow gives Caitlin her cash flow from operations, which is a good indicator of how well she is managing to bring in enough cash to support her lifestyle. Not so incidentally, the cash flow statement for a business is also separated by function. The major parts of this household functional cash flow statement—operating activities, capital expenditures, financing activities, and savings—are discussed more fully in the following sections.


Operating activities are the day-to-day financial functions of the household. This part of the household functional statement closely resembles a business income statement. The principal difference is that the household statement is recorded on a strict cash basis, while the business one includes noncash items. The operations segment can be segregated into cash inflows and outflows that we call income and expenses. Income consists of salary, investment returns, and other sources of operating cash. Expenses can be divided into nondiscretionary and discretionary items. Nondiscretionary expenses are the household’s overhead items such as interest expense,

People sometimes get confused by the impact of debt. They believe that repayment of debt is a good practice, which is, of course, true; however, they confuse lower debt with having higher cash flow for that period. The cash flow statement focuses on cash only. Borrowing $10,000 has the same effect on cash flow as earning a $10,000 after-tax bonus. That is why it is best to treat debt in a separate

section and to look beyond the bottom line cash number. By doing so, you can judge operating performance before the sometimes substantial influences of increases or repayments of borrow- ings. A closer examination of that section would show that although debt repayment is often regarded as a positive development, it remains a negative cash flow item.

Practical Comment Cash Flow and Debt

Chapter Five Financial Statements Analysis 115

rent, household, food, clothing, and taxes.1 These are largely fixed costs: We can’t alter them easily, particularly over short periods of time. Discretionary expenses are those you choose to make, principally because you get pleasure from them. Examples are entertain- ment, eating out, and vacation outlays. The difference between income and expenses is the cash flow from operations.

Capital Expenditures Capital expenditures are outlays on household-related matters that provide benefits be- yond the current year. They are a form of investment, as we will see in Chapter 8. Included are such items as cars, furniture, fixtures, and appliances. We want to display them sepa- rately because these cash outflows don’t occur regularly, so to include them with other costs could distort the operating figures. For example, a comparison of this year’s operating cash flow with last year’s would be clearer if it excluded a $20,000 payment to buy a car. The purchase of a car is a once in, say, five-year occurrence. By placing it in a separate section of the cash flow statement, we can more easily compare this year’s operating activities with last year’s. In addition to their positioning on the cash flow statement, the individual capital expenditures, particu- larly if they are large, also are placed as assets on the balance sheet.

Financing Activities Financing activities are responsible for the cash flows that come from changes in debt. Borrowing money has a favorable impact on cash flow because it increases the cash avail- able. Repaying debt has a negative effect on cash flow because it reduces cash resources. Additions to or subtractions from debt are reflected in the total debt outstanding, which is placed as liabilities on the balance sheet.2

Savings Savings is the cash left over after your operating, capital expenditure, and debt activities. It is also known, for financial statement purposes, as cash flow, representing prior cash inflows minus cash outflows. Investments that are not in the form of capital expenditures are treated as part of the savings section. Thus, savings placed into vehicles such as stocks is handled here.3

Savings can be outlaid for specific purposes such as retirement or a down payment on a home. The amount of cash available after such targeted investing is called net cash flow; it is the bottom line on the cash flow statement. It is the savings available for further investing or for spending in the next period. When the net cash flow figure is negative, it can be due to targeted investing. Alternatively, the figure may be positive only because of borrowing during the period. When there is a sig- nificant negative net cash flow figure before targeted investing or a positive one only because of borrowing, further analysis and possibly changes in household operations may be needed. Savings applied to investing, such as amounts for stocks and bonds, add to the amount shown under marketable securities in the balance sheet. Savings left in cash are included under cash at period-end on the balance sheet. Balance sheet cash at the end of the period less cash at the beginning of the period equals net cash flow on the cash flow statement for that time frame. A functional cash flow statement is provided in Table 5.3.

1 Taxes are sometimes shown as a separate category following nondiscretionary and discretionary expenses. 2 Capital expenditures are also a form of investment, but in people’s thinking and in practice, they are segregated from financial investments on the cash flow statement. 3 Keep in mind that interest on the debt is not placed in the finance section. It is a nondiscretionary over- head cost. It must be paid until the debt is retired. Interest expense is not included on the balance sheet.

116 Part Two Ongoing Household Planning

Traditional Household Cash Flow Statement In practice, many people currently use a cash flow statement that groups all inflows and out- flows together and makes few or no distinctions between flows based on operating, capital ex- penditures, and debt repayment. In that statement, pay down of debt and interest payments are lumped together and income tax payments are often placed at the bottom, just before the net cash flow figure. This approach, which we can call a traditional cash flow statement, ends up with the same net cash flow figure; its advantages are simplicity and custom. However, it is less useful as an analytical document for financial planners and individuals. This type of cash flow statement, using the same categories that appear in Table 5.3, is shown in Table 5.4.

TABLE 5.3 Functional Cash Flow Statement

2015 2016 2017 2018 2019

Operating Activities Income

Salary Business Investment Other

Total Income Expenses

Nondiscretionary Housing upkeep Health care Insurance Interest Alimony Food Clothing Transportation Personal Taxes Total Nondiscretionary Expenses

Cash Flow before Discretionary Activities

Discretionary Recreation/entertainment Personal Vacations Gifts and charitable contributions Hobbies Interest Other Total Discretionary Expenses

Cash Flow from Operating Activities Capital Expenditures

Discretionary Nondiscretionary

Total Capital Expenditures Financing Activities

Total repayments Additional debt

Total Financing Activities CASH FLOW

Targeted for retirement Targeted for other Net Cash Flow

Chapter Five Financial Statements Analysis 117

TABLE 5.4 Traditional Cash Flow Statement

2015 2016 2017 2018 2019

Income Salary Business Investment Other Total Income

Expenses Mortgages and property taxes Housing upkeep Food Clothing Health care Transportation Insurance Recreation and entertainment Vacations Hobbies Gifts and charitable contributions Contributions to pensions Net additional debt proceeds Capital expenditures Interest Other Taxes Total Expenses


People often have problems portraying their actual expenditures accurately: 1. Generally, they underestimate their expenses. In

budgeting, people think of those continuing expenses that they can remember and often exclude less frequent expenditures. This problem can be overcome by using software programs de- tailing records of expenditures or by making hard copies of records of checks paid and actual bank and investment account cash deposits and with- drawals. The simplest way to find out whether the estimation of past expenses is generally accurate is to use records of last year’s actual savings. By recording take-home (after-tax) in- come plus other cash inflows and subtracting the amounts deposited into savings accounts, people can obtain actual cash expenditures. We know

that estimated expenses often are materially lower than actual ones. An “other” category rep- resenting the balance between the two should be established and generally carried forward in projections of future expenses.

2. Many people and some programs blur or elimi- nate the distinctions between assets and liabili- ties, income and expenses, and cash inflows and outflows. For example, some people include on the cash flow statement repayment of debt, treating it inaccurately as an expense. Many peo- ple view it as such. Paying down mortgage debt increases the projected net cash people would re- ceive on the sale of a home and therefore their net worth. As you’ve seen, mortgage debt is best placed under a financing category on a func- tional cash flow statement.

Practical Comment Estimating Expenditures

In Table 5.5 you can see the differences between a functional cash flow statement and a traditional one; Example 5.3 follows as a practical example of the use of a functional statement.

118 Part Two Ongoing Household Planning

TABLE 5.5 Household Statement of Cash Flows

Traditional Functional Statement Statement

Calculates net cash flows properly Yes Yes Develops separate operational income statement No Yes Resembles business cash flow statement No Yes Segregates capital expenditures and financing activities No Yes Separates nondiscretionary and discretionary costs Sometimes Yes Handles revenues properly Yes Yes Is more simple Yes No Is more informative No Yes

Last Year This Year

Salary $120,000 $140,000 Investment income 4,000 3,000 Discretionary expenses 45,000 55,000 Nondiscretionary expenses 50,000 52,000 Capital expenditures 10,000 18,000 Debt—increase/decrease 8,000 (13,000) Retirement investments 12,000 14,000

SPENCER Functional Cash Flow Statement

Last Year This Year

Income Salary $120,000 $140,000 Investment income 4,000 3,000 Total Income $124,000 $143,000

Expenses Nondiscretionary $50,000 $52,000 Discretionary 45,000 55,000 Total Expenses $95,000 $107,000 Cash Flow from Operations $29,000 $36,000 Capital Expenditures ($10,000) ($18,000) Financing Activities $8,000 ($13,000) Cash Flow $27,000 $5,000 Retirement investments (12,000) (14,000) Net Cash Flow $15,000 ($9,000)

Example 5.4 Spencer had the following statistics for the past two years. Construct his functional cash flow statement and calculate his cash flow for the year.

As you can see, Spencer had a positive cash flow of $15,000 last year and a negative one of $9,000 this year. The $9,000 negative figure is somewhat misleading, however. The functional statement allowed us to see that cash flow from operations actually rose from $29,000 to $36,000 in the new year. The increase in capital expenditures and, most importantly, the de- crease in debt this year in contrast to the increase in borrowings last year led to the negative cash flow figure. As we discussed, the reduction in debt this year is actually favorable.


Financial statements are intended to make the household’s financial circumstances as clear as possible. A number of situations call for either the separation of figures on the statement or, more frequently, footnotes to them. Some typical areas that require separate treatment, often in- volving taxation matters, are discussed below for the balance sheet and the cash flow statement.

Chapter Five Financial Statements Analysis 119

Balance Sheet Retirement Assets Retirement assets that are in pension accounts typically consist of marketable assets such as stocks and bonds.4 They should be listed separately for two reasons. First, unlike per- sonal ones, retirement assets often cannot be turned into cash immediately or at least not without penalty. For example, many firms impose limits on taking money from pension plans, and the government generally imposes a 10 percent penalty on qualified pension withdrawals prior to age 59½.5

The second reason is that normal withdrawals from pensions are taxable. It can be use- ful to know what pensions would be worth on an after-withdrawal, after-tax basis. Where such withdrawals are scheduled to be made over a relatively short period of years, it is helpful to footnote the potential impact of taxation.

Life Insurance Much life insurance has no current value or a low cash value relative to its face amount. If it has a significant cash value, it belongs on the balance sheet. The face value, the amount to be paid in the event of death during the period the policy is in effect, should be given in a footnote.

Taxation and Unrealized Appreciation Investment assets are expressed on the balance sheet at their current value. It is useful for a footnote to the balance sheet to give their cost individually or, if there are many assets, a total cost figure. In that way, the effect of taxation on the gain upon ultimate sale can be estimated.

Liquidation Cost When we expect the proceeds from a sale of assets to be materially lower than the value placed on the balance sheet, it is a good idea to footnote the amount of liquidation costs and net proceeds. For example, if a large amount was placed in an asset that had an 8 percent redemption fee and there was a reasonable chance for liquidation, the footnote could say “subject to an 8 percent redemption fee.”

Cash Flow Statement The footnotes on this document often provide additional information on special charges for the year. For example, the housing category could footnote a large $3,000 repair on a home. When the other category is used for all miscellaneous expenses, the footnote could explain the substantial components of that category year by year. For example, the other category on the statement could consist of $2,000 including a $1,000 loan that may never be repaid and another $1,000 for a settlement on a disputed billing.


Pro forma statements are statements that include projections. The term is Latin for “as a matter of form.” Today, the use of pro forma refers to a presentation of data with some hypothetical numbers. A business eyeing an acquisition, for example, produces

4 Pensions from companies or the government that provide guaranteed income at retirement generally are not listed on the balance sheet. 5 Several exceptions to the 10 percent penalty on premature distributions exist, including distributions be- cause of permanent/total disability, payment for health insurance premiums while unemployed, purchase of a house (a penalty-free withdrawal of up to $10,000 for first-time home buyers), distributions made after a person over age 55 separates from service, receipt of money as part of substantially equal pay- ments for a person’s lifetime, distributions required as part of a qualified domestic relations court order (QDRO), and money withdrawn for educational purposes or for widows or others aged 59½ or more.

120 Part Two Ongoing Household Planning

6 Those that don’t occur in a steady yearly stream.

Projections frequently need to be thought through carefully. Often people say that they are satisfied with their current lifestyle and they project flat real expenditures. Nonetheless, their expenses tend to increase with their income even if their income rises at a faster pace than inflation. In other cases, they project a decline in expenditures with the intention of generating additional savings. Many, confusing a wish with future reality, never accomplish this. Also, projections for capital expenditures and other large onetime outlays on such items as

automobiles, furniture, home repair, weddings for children, large appliances, or trading up in homes are often left out. Systematically overstating cash flows can have a significant effect on yearly cash flow planning and, more importantly, on assumed periodic saving for retirement. When future yearly net cash flows are projected to be materi- ally higher than in the past, a more sober appraisal of future funds that will be made avail- able may be necessary.

Practical Comment Concern about Projections

pro forma statements that indicate how the company might look and perform after the deal goes through. A household might not acquire another, but its members can anticipate future income and expenses. The two statements we have been concerned with in this chapter, the cash flow statement and the balance sheet, can include projected amounts. The previous tables that showed functional and traditional cash flow statements and provided for future year figures in addition to current year actuals were, therefore, in part, pro forma. A written household budget and a statement providing projected retirement or insurance needs are also examples of pro forma statements. We include projections in a statement to better anticipate needs, to forecast resources to meet those needs, and to adjust our plans accordingly. For example, projections of the need to renovate a home over a period of years at a cost of $50,000 can lead to focusing atten- tion on this in the household savings rate and living costs.

Pro Forma Cash Flow Statement There are two principal approaches to making projections for a cash flow statement: the common rate and the separately estimated rate or amount.

Common Rate The common rate is the rate of annual increase that many household expenses share. As financial planners know, that increase is often based on an assumed future inflation rate. In the absence of specific information to the contrary, this rate is employed for much of the anticipated revenue and the majority of projected increases in expenditures.

Separate Rate Certain inflows and outflows cannot be estimated by using a projected rise in inflation. Increases in salaries, particularly among younger workers, are projected using a separate rate. Investment income can be projected based on an assumed return. Insurance costs are based on contractual rates, and mortgage interest and principal payments also are stated in that contract. Lumpy outlays6 or capital expenditures may be preplanned at a set amount. On the other hand, certain child costs including those for college are established in current terms and may rise at a rate that differs from inflation. In Table 5.6 you can see a breakdown of common projections.

Chapter Five Financial Statements Analysis 121

Pro Forma Balance Sheet The balance sheet can be a more difficult statement to forecast than the one for cash flows. That is because some of its figures include the impact of cash flows and outflows on them. For example, the investment account includes not only the growth rate on existing assets but also the deposit of new savings. Liabilities include the impact of cash inflows to re- duce the amount outstanding or the absence of cash flow, which results in a higher debt figure. For this reason, projected balance sheets are used less frequently than those for cash statements.

TABLE 5.6 Projected Cash Flow Statement

Explanation for Projections

Operating Activities

Income Salary As separately estimated or rate of inflation Business As separately estimated or rate of inflation Investment Assumed rate of return Other Total Income

Expenses Nondiscretionary Housing upkeep Rate of inflation Health care Rate of inflation Insurance Per contract where fixed; otherwise, rate of inflation Interest Per debt outstanding Alimony As stated Food Rate of inflation Clothing Rate of inflation Transportation Rate of inflation Personal Rate of inflation Taxes Based on separate tax calculation Total Nondiscretionary Expenses

Cash Flow before Discretionary Activities Discretionary Recreation/entertainment Rate of inflation Personal Rate of inflation Vacations Rate of inflation Gifts and charitable contributions Rate of inflation Hobbies Rate of inflation Interest At stated rate Other Rate of inflation Total Discretionary Expenses

Cash Flow from Operating Activities

Capital Expenditures Discretionary As separately estimated or rate of inflation Nondiscretionary As separately estimated or rate of inflation Total Capital Expenditures

Financing Activities Total repayments Per contract Additional debt As separately estimated Total Financing Activities

CASH FLOW Targeted for retirement As stated

Net Cash Flow

122 Part Two Ongoing Household Planning


Finance and accounting are different disciplines, which have alternative ways of present- ing transactions and results. Formal accounting employs GAAP, or generally accepted accounting principles. Most large businesses use GAAP accounting. Often the difference between finance and accounting lies in the importance placed on cash flows.

GAAP versus Household Accounting Businesses, which typically use generally accepted accounting principles (GAAP), and households have different ways of recording transactions. Household accounting is similar to a basic finance principle: Changes in cash generally determine results for a period. Business accounting is more sophisticated. Under GAAP, the business attempts a proper matching of revenues and expenses. Its goal is a fair presentation of business results for a period—say, within a year. Its results can involve cash and noncash items for a particular period. A simple example may be instructive (see Example 5.5).

Example 5.5 Under household accounting, when Dwight receives a $3,000 cash advance for a website de- sign project at year-end 2015, he would include that $3,000 in his household cash flow state- ment for 2015 even though he won’t actually earn the money until 2016. On the other hand, if BetterWebsitesRUs, Inc., receives a similar $3,000 advance from a customer, the company wouldn’t treat the money as income on its financial statements until the following year. The company would wait until it had expended the costs—say $2,500 in 2016—necessary to com- plete the transaction, thereby matching related revenues and outlays. By following GAAP procedures, the company’s results for 2015 wouldn’t look exceptionally good with $3,000 higher profits. Similarly, 2016 wouldn’t have lower profits from the costs of production without any revenues against it. The business accounting process would record a $500 profit ($3,000 revenues - $2,500 costs), matching revenues and expenses in 2016 when the transaction was completed. That reporting procedure is followed even though the cash was received in 2015, one year earlier. Most households don’t need to make the effort to follow GAAP principles in their record of cash flows. As a practical matter, though, Dwight might want to request the cash advance in January 2016 rather than in December 2015, to delay the receipt of taxable income to the next calendar year.

Household results for a period are provided on a cash flow statement, whereas business results are given on an income statement. For information on an income statement for busi- nesses, see Appendix I in this chapter. In sum, business accounting under GAAP attempts to report income and expenses, whether or not in cash, for a fair presentation. For house- hold reporting of the results for a period, only cash matters. Capital expenditures are outlays that have benefit for more than the current period. We’ve seen that households often combine them with other outflows on the traditional cash flow statement. Businesses capitalize them as assets on the balance sheet instead of expensing them on the income statement.7

Depreciation is the projected reduction in asset value due to wear and tear or obsolescence. It is a tax-deductible expense on the business income statement. Because the decline in asset value didn’t involve a cash transaction, it isn’t recorded on the household’s cash flow statement. Finally, GAAP generally requires that businesses record transactions on the balance sheet at original cost less accumulated depreciation. Households generally record assets at their fair market value. Consider Example 5.6.

7 The business would use accruals amounts due and amounts owed business accounts, which aid in the matching of revenues and costs.

Chapter Five Financial Statements Analysis 123

Example 5.6 Sally and Henry bought identical cars. Each paid $24,000 for their assets. Sally used the car for business purposes to travel to clients. Henry used it personally to transport his family. Sally took $7,200 of depreciation8 on the car in the first year. According to GAAP methods, the tax de- duction on $7,200 created a $2,400 tax benefit for Sally. Show the difference between Sally’s business and Henry’s personal treatment of the transaction assuming that the car had a fair market value of $26,000 at the end of the year.

8 Depreciation amount equals 30 percent of the car’s depreciable basis or purchase price.

Henry—Household Sally—Business Treatment Accounting Treatment

Income statement $7,200 pretax depreciation Generally there is no separate $2,400 tax benefit income statement. $4,800 deduction in net income Cash flow statement Noncash depreciation of $7,200 added to net $24,000 cash outflow placed income to obtain cash flow from operations. on statement.1

Capital expenditure section will reflect $24,000 outflow. Balance sheet Original cost $24,000 Recorded at $26,000 fair Less accumulated depreciation 7,200 market value.

Net amount on balance sheet $16,800

1 On regular statement grouped with other cash charges; in functional statement included under capital expenditures.

Recording Transactions In Table 5.7, you can see a summary of the differences between business and household meth- ods of recording transactions as well as the definitions of various financial statement items.

TABLE 5.7 Recording Transactions: Business versus Household

Item Explanation GAAP Business Finance

Balance sheet Assets and liabilities at Based on original cost Based on current fair a given point in time market value of assets Performance for period Cash flow statement giving A proper matching of Cash inflows and outflows operating performance revenues and costs for only in a cash flow state ment for the period the period in an without regard to income statement proper matching Revenues Sale transactions Recorded when fairly Recorded when cash is represents a transaction received Expenses paid Cost transactions Recorded as necessary Recorded when cash is for proper matching disbursed with revenues Profits Earnings for period A “fair” presentation of No exact equivalent; results for the period replaced by cash inflows minus cash outflows Capital expenditures Outlays providing Capitalized as asset on Recorded as outflow on extended-period benefits balance sheet, not as flow statement; recorded an expense on at fair market value on income statement balance sheet Depreciation Amount an asset has Recorded as an expense on Not recorded declined in value for income statement based on the period original cost; deducted from asset on balance sheet Asset value on balance sheet The assigned worth of an Recorded at original cost Recorded at fair market item at a point in time less depreciation value

124 Part Two Ongoing Household Planning

Back to Dan and Laura FINANCIAL STATEMENTS ANALYSIS Laura had dropped in alone one afternoon seeking an explanation of financial statements. She felt a little lost during conversations about financial statements with their friends and was looking to become more aware about balance sheets, cash flow statements, and so on.

Here’s what I told her: Laura, I’m glad you were forthright about your lack of knowledge of balance sheets and cash flow statements. The truth is that many people aren’t that familiar with them. Let me see if I can enlighten you in a brief time. As you’ve learned, financial planning is a process that sets goals. But goals cannot be set abstractly. Instead, they must be set in connection with resources. The balance sheet indicates the resources that are available. It is a statement of assets, liabilities, and house- hold equity at a point in time. Assets are items that have value to the household going forward. Assets are placed on the left-hand side of the balance sheet. They can be separated into current assets and long-term assets. Current assets are those that are likely to be consumed within the year whereas long-term assets extend beyond a one-year time frame. The balance sheet is separated into current assets, marketable investments, retirement in- vestments, real estate, household assets, and other assets such as household overhead and lei- sure time. The most prominent business asset for the household is typically the future income stream of its wage earners, called human assets.9 But because human capital can’t be sold, it isn’t usually placed on balance sheets. Other business assets could be a computer or business car. Marketable assets might include stocks and bonds. Retirement assets are, of course, seg- regated for use when you’re no longer earning a salary. Real estate is your home. Household assets might include a car, a refrigerator, a television, a VCR, a stereo, a boat, and so on. Liabilities are items the household owes. They are placed on the right-hand side of the balance sheet. Credit card debts, taxes payable, and mortgage debt are all liabilities. They too can be split into current and long term based on whether they are due within one year or beyond that period. Household equity is the difference between assets and liabilities. It is intended to show how much the household is worth at that point in time. Household equity can be relatively small or even negative when household members are young and generally increases as their marketable investment portion rises. Net working capital is a figure reached by subtracting current liabilities from current assets. It represents the cash that will become available over the next 12 months to pay li- abilities that will fall due over that period. Consequently, a strong balance sheet will have a positive net working capital.

Balance Sheet Your current financial condition as shown in the following statement is fairly positive. Your biggest strength is having $137,000 in marketable assets. On the negative side, you have $27,000 in current liabilities and only $3,000 in current cash. When your long-term liabili- ties of about $59,000 are added in, your net worth is a positive $88,000. In addition, both

9 For a discussion of human capital, see Theodore W. Schultz, “Capital Formation by Education,” Journal of Political Economy 68, no. 6 (December 1960): 571–83; Gary Becker, “Investment in Human Capital: A Theoretical Analysis,” Journal of Political Economy 70, no. 5 (October 1962): 9–49; Daron Acemoglu, “Human Capital Theory,” Bilkent, July 2013. econ.bilkent.edu.tr/wp-content/uploads/2013/08/Lecture- Bilkent-20131.pdf. Daron Acemoglu is Elizabeth and James Killian Professor of Economics at Massachusetts Institute of Technology.

Chapter Five Financial Statements Analysis 125

you and Dan have strong future income prospects that aren’t included as assets in the cur- rent statement. The only negative is a weak net working capital position if we exclude your money market funds under marketable investments as you like us to because you don’t want to dip into them. Excluding those assets, your current liability exceeds your current assets. The important thing to recognize is that your balance sheet is currently fairly strong. However, it doesn’t reflect your human assets, your future earning ability. With the proper care, these human assets will bring about an even stronger future financial position. The cash flow statement is sort of an income statement for the household. However, it is broader than a business income statement. It includes not only cash inflows such as job- related income and day-to-day expenses, but also capital expenditures—larger outlays for items that last for more than one year—and debt indicating whether borrowings have in- creased or declined for the year. A functional cash flow statement separates these catego- ries to make it simpler to analyze them. Once cash outflows have been deducted from cash inflows, you have the net cash flow for the year. That is the amount of cash that you’ve received or expended during the year. Under the finance disciplines approach, cash is often the focus and is most easy to identify. All you do is look at your cash at the beginning of the period and compare it with the end- of-period figure. The difference should be net cash flow for the year. I hope this is helpful. If there is anything you’d like to ask, contact me or we’ll talk about it at our coming cash flow planning meeting. At that time, I’ll show you your cash flow statement.

College Student Case Study and Review: Amy and John FINANCIAL STATEMENT ANALYSIS It was apparent that there was a dichotomy in knowledge of financial statements between John, who was a business major, and Amy, who was studying liberal arts. This topic was important in personal financial planning (PFP) analysis, so I decided to start with the basics.

Assets Liabilities

Current Assets Current Liabilities Checking accounts $2,800 Credit card debt $20,000 Refund due on returned clothing 200 Educational loan—current 7,000 Total Current Assets $3,000 Total Current Liabilities $27,000 Marketable Investments Long-Term Liabilities Money market funds* 34,000 Educational loan—LT portion 39,000 Stocks and stock funds 103,000 Loan from parents 20,000 Total Marketable Investments $137,000 Total Long-Term Liabilities $59,000 Pension Assets Total Liabilities $86,000 401(k) plans 6,000 IRAs 4,000 Total Pension Assets $10,000 Household Assets Autos 12,000 EQUITY Furniture and fixtures 7,000 Other 5,000 Household equity 88,000 Total Household Assets $24,000 Total Equity (Net Worth) $88,000 Total Assets $174,000 Total Liabilities and Equity $174,000

*Not considered part of the current assets because the amount won’t be used currently. Instead, it is set aside under marketable investments for long-term use.

126 Part Two Ongoing Household Planning

Only two financial statements for the household really count: the balance sheet and the cash flow statement. The balance sheet is a statement of assets and liabilities at a certain point in time. This statement shows household equity, which is also called household net worth. Except for the type of assets, it is similar to a business balance sheet. The cash flow statement reports the cash inflows and outflows for a particular period of time, often a year. In contrast to a business cash flow statement, it incorporates the income statement. Therefore, all inflows and outflows are included, arriving at a net cash flow. There are two methods of presenting the household cash flow statement: traditional and functional. The traditional household cash flow statement groups all cash flows together. A functional cash flow statement separates the flows into four basic activities as shown in the following table.

Functional Cash Flow Statement

Type Explanation

Operating activities Household’s day-to-day activities. Records of these activities is equivalent to the income statement of a business.

Income Cash inflows such as salary and investment income. Expenses Cash outflows separated into nondiscretionary and discretionary. Nondiscretionary Basic expenses for items such as food and housing maintenance. Discretionary Expenses chosen because they provide pleasure. Obviously, they vary

from person to person. Examples are vacations and entertainment. Cash flow from operating activities Difference between income and expenses. Capital expenditures Outlays for items that benefit the household beyond the current

year. Purchasing a car and installing a roof are two examples of capital expenditures.

Financing activities Cash inflows and outflows that come from changes in debt such as borrowing or repaying debt. Examples are taking out a mort- gage or paying off a credit card balance.

Savings Amount remaining after the three items just mentioned. Targeted savings is the amount put away for reasons such as retirement or down payment on a home. Savings is another name for cash flow after expenses are deducted from income.

Cash flow = Operating activities - Capital expenditures + Financing activities

Net cash flow = Cash flow - Targeted savings

Note that borrowing money, which some people think of as a negative, actually adds to cash flow. The functional statement presents a clearer explanation of household results for the period and an easier comparison with other periods. A projected cash flow statement is used to reveal future financial needs or anticipate excess funds. The projections in such statements generally use an expected rate of inflation as the growth rate of future flows. In certain cases, however, items such as salary income are separately estimated in order to include a calculation for estimated tax obligations. Contractual terms can be used to project expenses, such as rent. It is important to recognize that finance in general and personal finance in particular use cash only as their benchmark for financial reporting. Unlike accounting, personal financial state- ments have no accruals, prepaid expenses, or depreciation as are found in generally accepted accounting principles (GAAP). For example, if you bought a car for $30,000 that you knew had a useful life of 10 years and at the end of the period would be junked and you then bought a new one for $40,000, GAAP could show depreciation of $3,000 for each of the 10 years you had the original car. Finance, conversely, would show an outflow of $30,000 at the beginning of the period and another outflow of $40,000 10 years later, when you buy the next car.

Chapter Five Financial Statements Analysis 127

As you can see, Amy, personal finance doesn’t try to match revenues and costs “prop- erly.” Instead, in PFP, reports of revenues and costs simply record the impact of cash flow items. In addition, the balance sheet for PFP is stated at fair market value whereas a busi- ness balance sheet shows original cost.

Summary Financial statements can provide an objective way to assess your financial condition. • The balance sheet provides your assets, liabilities, and equity at a given point in time.

• The cash flow statement serves as a kind of income statement for the household that indicates how well it is operating, but its coverage is broader than an income statement for a business.

• The cash flow statement can be divided into operating, capital expenditures, debt, and net cash flow figures.

• Finance focuses on actual cash generated whereas accounting attempts to match income and expenses even when cash isn’t received or paid. In forming a balance sheet, finance uses fair market value; accounting uses original cost.

Key Terms assets, 124 balance sheet, 110 capital expenditures, 115 cash flow, 115 cash flow statement, 113 current assets, 110 depreciation, 122 financing activities, 115 functional cash flow statement, 113

household assets, 111 household equity, 111 household net worth, 111 human assets, 111 human-related assets, 111 liabilities, 111 long-term assets, 124 marketable investments, 111 net cash flow, 115 net working capital, 124

operating activities, 114 pro forma statements, 119 savings, 115 statement of cash flow, 113 statement of financial position, 110 traditional cash flow statement, 116

studyfinance.com/lessons/finstmt StudyFinance.com This site provides an introduction to financial statements and financial statement concepts.

sba.gov/ombudsman/7046 U.S. Small Business Administration This site offers information on the basics of financial statements. You can learn to un- derstand and prepare the different parts of a balance sheet and an income statement.

hoovers.com Hoovers Online This site provides an online database for company information including financial statements and stock performance.

sec.gov/edgar.shtml SEC’s EDGAR This is the link to the Security and Exchange Commission’s EDGAR (electronic data gathering, analysis, and retrieval system) database where SEC filings on a company’s fi- nancial performance and other operating information such as 10-Ks and 10-Qs are posted.


128 Part Two Ongoing Household Planning

1. What is a balance sheet, and why is it important?

2. Why segregate a balance sheet by type of asset and type of liability?

3. What is a cash flow statement, and why is it important?

4. Detail the sections of a functional cash flow statement.

5. Contrast a functional and a traditional cash flow statement.

6. Is an increase in debt a plus or minus from a cash flow standpoint? Explain.

7. What is a pro forma statement? What is its use?

8. Outline some expenses of a pro forma statement that cannot use inflation to project their growth and indicate what rate should be used.

9. Contrast the views of finance and accounting on recording operating results.

10. In your opinion, which presents results more fairly, finance or accounting? Explain.

11. What are reasons that a person may have a poor net cash flow yet be considered to be in good financial health?

12. What is the major difference between household accounting and business accounting?

13. Elaborate on the two approaches to making projections for a cash flow statement.

14. What is household equity, and how do you calculate it?


A client provides a current balance sheet to the financial planner during the initial data- gathering phase of the financial planning process. This financial statement will enable the financial planner to gain an understanding of all of the following except

a. Diversification of the client’s assets.

b. Size of the client’s net cash flow.

c. Client’s liquidity position.

d. Client’s use of debt.

A cash-basis taxpayer includes income from a service business when

a. The services are performed.

b. The client is invoiced for the services.

c. The client’s check is deposited in the bank.

d. The client’s check is received.

The estimated value of a real estate asset in a financial statement prepared by a Certified Financial Planner licensee should be based upon the

a. Basis of the asset, after taking into account all straight-line and accelerated depreciation.

b. Client’s estimate of current value.

c. Current replacement value of the asset.

d. Value that a well-informed buyer is willing to accept from a well-informed seller where neither is compelled to buy or sell.

e. Current insured value.




CFP® Certification Examination Questions and Problems

Chapter Five Financial Statements Analysis 129

Case Application FINANCIAL STATEMENTS ANALYSIS The Balance Sheet Richard called and said that he had compiled a list of assets and would send it. It came a few days later. His assets included a home worth $300,000, approximately $350,000 in securities, two cars worth $40,000 with loans of $15,000 against them, and other assets including jewelry (worth $5,000), art ($5,000), and furniture ($7,000). Richard and his wife had money market funds of $2,000, a bonus due of $5,000 net of taxes, and credit card payments due of $12,000. Their house had a $130,000 mortgage.

Case Application Questions 1. Construct the balance sheet.

2. Does it look substantial?

3. Would you tell Richard and Monica that it was strong? Why?

4. Complete the balance sheet section of the plan.

Appendix I

Income Statement An income statement reports on profits for a fixed period of time. A publicly held business often identifies net income for a quarterly or yearly period. The household statement of profitability can be said to be shown following the cash flow statement, particularly under the functional cash flow statement. As discussed in this chapter, business reporting under GAAP is more complex, which necessitates a separate income statement. An income statement can take many forms depending on the industry or reason for its compilation, but it often can be separated into the following parts:

Parts of Income Statement Explanation

Sales Provides all the inflows that give the company its inflows from direct operating activities for the period. Often called “Revenues,” which are transactions for goods and services sold to customers.

Cost of Goods Sold These are outlays that are directly related to the goods and services sold to customers. For example, a beverage company would include such items as the glass or aluminum container and the cost of the beverage ingredients.

Gross Profit This is the sales less the cost of goods sold. It indicates how much profit has been generated before other necessary costs are deducted.

Selling, General, and These are the costs that are outlaid to help support operations. They include such items as sales or Administrative Expenses marketing expenses, salaries, rent, and research and development costs. Other Expenses This category includes interest expense and miscellaneous expenses such as nonrecurring write-offs. Pre-Tax Income Profits for the period before taxes. Tax Tax expense to be paid to the government based on profits. Net Income The benchmark for determining profits for the period. It is revenues less all expenses.

Notice that outlays for capital expenditures and inflows or outflows for debt borrowings or repayments aren’t included. These are included in a separate cash flow statement along with one figure from the income statement: net income.


Chapter Goals

This chapter will enable you to:

• Apply cash flow analysis to household finance.

• Treat cash flow planning as a central activity in PFP.

• Utilize budgeting techniques effectively.

• Develop savings approaches.

• Employ financial ratios as an evaluation method.

Dan and Laura had a problem. They were operating on two tracks: Dan was saving money and at the same time Laura was spending it. The net impact on the household was unfavor- able. Something would have to be done fairly quickly.

Real-Life Planning

The advisor was asked by clients of his to see their daughter and her husband. The clients were conservative people who pronounced themselves “depression babies,” which meant they grew up in a poor economic climate in the 1930s when a dollar really had to be stretched. They felt their daughter’s family was irresponsible, that they were spending money on things they couldn’t afford and not saving a penny. Would he see them? The parents would pay for the visit. Eileen and her husband Phil were a young couple with two children. She was a teacher, he a social worker. They lived on relatively modest incomes and had high special costs for their children. When the advisor met with them, they appeared to be vaguely depressed, perhaps because they knew why Eileen’s parents had suggested the visit. Their living costs did not seem extravagant to the advisor, and the “splurging on a vacation” mentioned by her parents turned out to be a $1,000 trip to a local resort town, all costs, even children- related outlays, included. The advisor thought to himself this wasn’t the first time there was a difference in finan- cial approach between parent and child. People of the parents’ generation often saved automatically because of their fear of the unknown, while the children’s generation was often more optimistic about the future and needed a reason for saving. In addition, if Eileen stayed at her current job, she would receive a government pension, which would help cover retirement needs. The advisor asked them whether they would like to have their own home instead of the inexpensive apartment they lived in. They said very much but that it wasn’t possible given their current finances. They said they were stuck in their current small apartment. The advisor thought they weren’t only stuck in an apartment, they seemed stuck in a rut.

Chapter Six

Cash Flow Planning

Chapter Six Cash Flow Planning 131

The advisor asked if he could make it feasible, they would like to own a home now. For the first time their faces brightened and they looked at each other and said yes. He explained how it could involve some sacrifices and that they would all work together to identify them. The couple mentioned they had no savings at all. The advisor mentioned that he would speak to Eileen’s parents about helping fund a down payment and made a mental note to assure the parents that they could afford it. The advisor looked over at Phil, who then volunteered to ask his parents. Both sets of parents agreed to help. The advisor and the couple worked on some areas of spending that could be cut back mod- estly. Phil mentioned that he could offer therapy sessions in the basement of a home if it had a separate entrance. A cash flow statement with its current breakeven payment was con- structed and a pro forma one for a budget with higher income; higher after-tax housing-related costs, particularly mortgage costs; and lower other expenses was drawn up. The figures fit. With some direction by the advisor on affordability and the bidding process, Eileen and Phil selected a house. Although local housing prices had recovered somewhat from the plunge during the financial crisis, the market was still reasonably priced; so, the young couple were able to find a desirable place they could afford. Their new home turned out to be close to Eileen’s parents’ home, a great advantage to all of them. The next time the ad- visor saw Eileen and Phil, they talked about how grateful they were. The advisor smiled and thought to himself that the ability to positively affect people’s lives is what makes financial planning so worthwhile. It wasn’t the compensation, which was modest. To the couple, the advisor was almost a magician, producing a home where none seemed possible. To the advisor, he had set people on a new course; they now had both a new investment and a higher quality of life. He wished cash flow planning for household goals was as simple for all his other clients.


The heart of personal financial planning is cash flow, which is literally the amount of cash generated from household activities. It includes those items, such as our jobs, that produce cash flows and those items that utilize them, such as our living costs. The reason cash flow planning is often the first part of financial planning to be analyzed is simple. Cash flow underlies all major household decisions. Thus cash flow has the same status that food has for the individual or energy has for business. Cash flow is the lifeblood of household activities. A good supply of cash flow enables us to operate and plan for the future. A poor supply of cash flow provides us few or no choices: We are constantly trying to catch up with our obligations. Often a weak cash flow arises from poor planning and control of expenditures. All parts of a financial plan must incorporate cash flow considerations. After all, financial planning deals with how we allocate limited resources. Whether we are deciding how much to spend on finishing the basement or the amount to put away for retirement, cash is involved. In this chapter, we concentrate on one segment of the financial plan: current operating needs. We briefly discuss lifestyles and provide reasons for saving and using sound bud- geting techniques. Cash flow planning is a matter of projecting the sources of cash and the household uses of it, thereby determining available cash flow for both identifying savings needs and generating free cash flow. When targeted savings have been planned properly, free cash flow can be used for additional spending today, invested for future spending, or put aside to reduce household risk. This chapter discusses purchasing power, emergency funds, liquidity, and marketability as parts of the planning system. It next provides a step-by-step description of the budgeting

132 Part Two Ongoing Household Planning

process. The chapter also discusses financial ratios, which provide an objective way of helping determine financial health. The chapter’s planning objective, then, consists of three parts: recognizing the impor- tance of cash flow to achieving goals, learning how to identify savings problems, and establishing what can be done in practical terms for personal financial planning (PFP).


Cash flow planning refers to the scheduling of current and future cash needs to achieve household goals. Cash flow planning can include such objectives as supporting a current lifestyle, paying off credit card debt, and saving for a vacation. More sophisticated and long-term goals that can be achieved through cash flow planning include reducing tax lia- bilities and planning for retirement. When we discuss cash flow planning, we are interested in what we do with our money. Lifestyles vary significantly. Some people live simply; the identities and goals of others involve spending on visible signs of achievement and status. In very basic terms, we have a choice between spending and saving. To spend is to add to our standard of living today. To save is to provide for future needs. Establishing how people differ in the way they spend their money is generally not of con- cern to advisors; people typically have no difficulty in spending. However, many people have difficulties in generating the amount of savings they need despite a host of good rea- sons for doing so. Example 6.1 discusses lifestyles and spending and savings strategies. It is followed by a fuller exploration of savings, often the focus of households and advisors alike.

Example 6.1 The Smiths and the Joneses were two couples who lived on different sides of town. The Smiths lived in a big house financed mostly through debt and had many obligations connected to it. The Joneses lived more modestly than the Smiths. The Smiths never seemed to have enough money, and one day Mr. Smith had to ask his firm for an advance because he didn’t have enough money to make the mortgage payments on the luxury house he bought at the peak of the real estate boom. Mr. Jones, who made less money, let his cash flow dictate his spending policies, including his home purchase. He always had a number of spending alternatives be- cause he always generated a positive cash flow.

Reasons for Savings In reality, there are a number of reasons for savings. We start with the classical, pure life cycle motive:1

1. Pure life cycle motive. To provide monies to even out differences in earnings over time. A key motivation is to build up resources for retirement when work-related earn- ings are no longer available.

2. Investment motive. To take advantage of investment opportunities that can make achieving financial goals easier.

3. Down payment motive. To provide funds for the down payment or full purchase of longer-lived assets such as durable goods or educational expenditures.

1 Adapted from Martin Browning and Annamaria Lusardi, “Household Savings: Micro Theories and Micro Facts,” Journal of Economic Literature 34, no. 4 (1996), 1797–855, which, in turn, was adapted from J. Maynard Keynes, The General Theory of Employment, Interest and Money (London: MacMillan, 1936). See also Patricia J. Fisher, “Saving behavior of U.S. households: a prospect theory approach” (doctoral dissertation, Ohio State University, 2006), etd.ohiolink.edu/ap:0:0:APPLICATION_PROCESS=DOWNLOAD_ ETD_SUB_DOC_ACCNUM:::F1501_ID:osu1155590726,inline.

Chapter Six Cash Flow Planning 133

4. Precautionary motive. To provide a fund to cover future uncertainties such as fluctuat- ing income, sickness, inflationary effects on expenditures, and so forth.

5. Improvement motive. To sacrifice today so that your future lifestyle can improve.

6. Independence motive. To accumulate sufficient wealth to be able to be financially in- dependent after working until reaching a certain age. You may not want to retire but to derive pleasure from a sense of independence, power, and prestige.

7. Bequest motive. To accommodate funds to provide for nonhousehold members whether they are children, other relatives, friends, or charities.

8. Hoarding motive. To accumulate investments with no intention of converting them into purchases in the future. In effect, pleasure comes from the accumulating the money itself or the power and cachet that having it brings.

People don’t usually calculate the amount of money they need to save and then do it. Instead, many need assistance. Next we describe several ways to help people save by im- proving budgeting practice.


Budgeting is a method of planning current and future household cash flows to determine needs and adhere to desirable allocations of resources. There are two types of budgeting techniques: formal and informal. Informal budgeting involves less detailed planning, sometimes just simply thinking about household planning such as a down payment on a car. The majority of budgeting planning is done this way. In general, many people dislike formal budgeting, which in- volves enumerating specific household figures in detail. They find it time consuming and do it only when highly motivated. Formal budgeting reflects all categories of household expenditures; usually in the form of a document, it is said to be a household budget. This budget is a type of pro forma cash flow statement with a purpose. (For an example of a formal budget, see the projected cash flow statement for Dan and Laura on page 144.) Because little can be done about fixed expenses, budgeting tends to focus on discretionary items. By thinking about and writing down the amount planned for each category, house- holds have several goals. Some of them include prioritizing outlays based on household preferences and needs, reducing or eliminating impulsive purchases that may be regret- ted later, not being caught short of cash funds, and saving enough money for future needs and contingencies. In theory, saving is a mechanical process. People decide how much savings they require to fulfill their objectives and then they mechanically implement the plan. In reality, human

Steady savings has an underappreciated advantage. Stocks fluctuate over time. Dollar cost averaging sig- nifies buying portions of intended investment amounts over time or as new savings become avail- able, thereby obtaining a price that averages out its highs and lows. To investors, it can prevent worrying

so much about purchasing at a time just before an initial or a further drop in the market. To advisors, it can help overcome a tendency for their clients to stay out of investments for a period of time, and some advisors believe for the wrong period of time when the market has already declined.

Practical Comment Steady Savings

134 Part Two Ongoing Household Planning

People may intend to save but find themselves with no money left at the end of the pay period. This lack of effectiveness can be overcome in several different ways.

SIMPLE STRUCTURAL APPROACH • Treat savings as another expense. Write a check to

savings each period at the same time that you pay fixed monthly expenditures. In popular terminology, this practice is known as “pay yourself first.” Contributing regularly to an employer- sponsored retirement plan such as a 401(k) via pay- check withholding has proven to be an effective way to make saving a budget item.

• Alternatively, have cash automatically wired to a separate savings or investment account when the payroll check is deposited.

• Develop a budget—detailed list of income and expenses with planned expenditures limited to accommodate a desired amount of savings.

PROVIDE MOTIVATION: “THE BUCKETS APPROACH” People find it easier to save when they have a concrete goal in mind. It is simpler to motivate savings when there is a direct connection between savings and the goal. Therefore, a slush fund for total savings is not as effective as separate accounts for each need. These accounts can be called “buckets” with one bucket for retirement, one for children’s college education, another for a down payment on a house, and so on. For example, Adam and Christine Green created a 529 college savings plan for their newborn daughter Nicole. They make monthly contributions to this plan and are not tempted to use the money for other pur- poses because it’s considered Nicole’s college fund.

ELIMINATE OPTION TO SPEND When keeping to a savings pattern even with struc- ture proves difficult, take one of the following actions: • Place money in accounts that have penalties for

early withdrawals such as pension accounts, tax- deferred annuities, or life insurance policies. Participants in employer-sponsored retirement

plans such as 401(k)s, for instance, face consider- able obstacles if they attempt to gain access to their accounts. Loan amounts are limited, and loan repayments typically are withheld from the borrower’s future pay.

• Alternatively, contract for a house and undertake large monthly mortgage payments. Aside from potential appreciation on the home, the savings will come from accelerated pay down of debt, which leads to increased equity in the house.

REDUCE TEMPTATION Buying on impulse can undermine savings efforts. To overcome this: • Stay away from stores that may tempt consumers

to spend more than needed.

• Carry credit cards only for planned expenditures and for vacations. Try to use cash as much as possible.

MINIMIZE DISCOMFORT People are reluctant to cut back on current spending because they can perceive limiting spending as result- ing in a decline in their standard of living. They are more agreeable to savings based on future increases in income. Therefore, saving a fraction of the extra money obtained from raises before the new money en- ters the spending stream can lead to successful saving.

OTHER REASONS FOR NOT SAVING There can be reasons other than a lack of discipline that account for why people don’t save. They may not have a strong ability to correctly visualize the long-term future or estimate future revenues or cur- rent savings needs. They just may prefer spending more today rather than in the future. They may feel that their life span is uncertain and therefore assured spending today provides pleasure. They may value simpler, less costly pleasures when they retire and want more material ones now. When choices are made rationally, there is little that should be done. However, a financial planner can explain the repercussions of not saving in visual factual terms that are often persuasive even for people who have the spend-for-today mindset.

Practical Comment How to Increase Savings

behavior intervenes. We know that many people have trouble saving money. That can be true even in higher-income households that some would say have the resources to save comfortably. Detailed written budgets are often a means of establishing financial structure for those who need it. These budgets may be drawn up in response to special circumstances such as planning for a specific large outlay, material debts, or a general inability to save.

Chapter Six Cash Flow Planning 135

The budget, then, can become a detailed framework for the future. Projected figures are compared with actual ones once the time period being measured has been completed. When there are notable differences, the reasons for them are analyzed and subsequent bud- get figures may be adjusted or spending patterns altered to bring actual performance in line with projections. Consider the case of Dorothy in Example 6.2.

Example 6.2 Dorothy had a problem. She planned to save some money each month. At the end of each month, however, she found herself a few hundred dollars further in credit card debt. She set up a rough budget for the year. As you can see, at the end of the year, the actual figures were different:

Difference (Actual – Budgeted Actual Budgeted)

Salary $66,000 $66,000 $0 Nondiscretionary expenses (43,000) 43,000 0 Discretionary expenses (15,000) (25,000) (10,000) Debt repayment (3,000) 2,000 5,000 Retirement savings 5,000 0 (5,000) Net cash flow $0 $0 $0

Dorothy looked at the difference between budgeted and actual figures. Her discretionary expenses were well above the budget amount. As a consequence, she was not able to save any money and, in fact, went further into debt. She decided to set up an item-by-item household budget. She made what she thought were realistic projections. Her cash flow statement pro- vided for both savings and repayment of debt. She vowed that she would not spend a single new dollar in the new month unless the prior month’s actual cash flow met expectations. There are a number of items that need to be considered when establishing pro forma bud- geting operations in general or a detailed household budget.

Purchasing Power Purchasing power is the amount of goods and services a fixed sum of money can buy. Because of inflation, a single dollar is expected to buy fewer and fewer goods the longer the time period before purchase.2 In making projections of salaries and household costs, inflation must be taken into account.

Emergency Fund In making cash flow projections, it is important to have liquid assets. We want the ability to turn assets into cash quickly without a high transaction cost or loss of principal. Cash flow

Financial planners are aware that in order to be conservative, some people keep their salaries level in making projections. When projections extend over a number of years, extreme distortions can occur. Often the solution is to express revenues and expenses in current dollars and then increase

these items when appropriate each year by the inflation rate. When that is done, statements are generally more accurate. Such steps can help deal with purchasing power risk, the risk of having your money decline in what it can buy over time due to inflation.

Practical Comment Conservative Projections of Income

2 Of course, if our country were to undergo deflation—that is, a continuing decline in the rate of overall prices—the opposite would be true.

136 Part Two Ongoing Household Planning

projections are subject to the risk of unexpected circumstances; we may need unplanned-for cash quickly. Often such cash comes from a liquid emergency fund set up specifically for that purpose. There are many reasons why we may need to use an emergency fund. For example, we may unexpectedly be laid off in our jobs or receive a lower-than-anticipated bonus. Alternatively, our costs may rise due to health or extensive repairs to the house or car. The amount that you place in an emergency fund depends on the degree of risk you face and the availability of your borrowing alternatives. Risk would be higher for a one-wage- earner household when the person works in the fickle entertainment industry than when two people work in more stable industries. Other considerations in a decision on the size of an emergency fund include projections of future free cash flow to be generated; the amount of debt outstanding; and the availability of other assets such as stocks and bonds to be tapped under emergency circumstances.

Liquidity Substitutes Businesses often prefer to keep as little in liquid assets as possible consistent with their risk requirements. In that way, they can put their monies into higher-earning assets in their business. We saw that households likewise often desire to place their funds into higher- earning assets, or they can choose to spend a higher sum today. As an alternative, house- holds have liquidity substitutes, which provide another way of raising cash, often in connection with unplanned-for developments. Two types of liquidity substitutes are debt and marketable securities. The access to and use of debt is growing in the United States. Cash needed for short-term, small emergencies can be accessed through credit card debt whereas large cash resources needed for extended periods of time can be generated through bank debt— particularly home equity loans, when applicable. (However, many home equity credit lines were frozen or abolished in the wake of the 2008–2009 financial crisis, so they may not be a certain source of liquidity.) We examine the advantages and disadvantages of using such debt in Chapter 7. Marketable securities are publicly traded financial assets for which a current market value can be determined. Examples include stocks, bonds, and mutual funds. Marketable securities are typically easy to sell in order to raise cash, but they don’t qualify as fully liquid because the household might incur a loss on a sale.

Figures for the size of emergency funds often range from three to six months of expenses. If Marge typi- cally spends $5,000 a month, or $60,000 a year, for instance, she might want to hold $15,000 to $30,000 in a day-to-day bank account or a money market fund than she can tap easily in case of an emergency. Such liquid accounts may have low yields, however. Given an ability to borrow money and to convert other assets into cash, the three-to six-month rule of thumb may be simplistic. Because there are a num- ber of other factors to consider, they should be com- pared with the projected gain from holding a lesser amount of liquid savings and investing more money.

As we discussed, the potential for higher return and the ready access to liquidity substitutes are probably among the major reasons that a large number of people hold less than a quarter or half year’s living costs as an emergency fund. Many of these people maintain no emergency fund at all. A reasonable approach may be to establish an emergency fund with liquid assets. The monies would come from savings with no debt used to gen- erate the cash needed. However, the size of the emergency fund could be influenced by the access to debt or to longer-term investments in the event that the emergency was of great scope or duration.

Practical Comment Size of Emergency Funds

Chapter Six Cash Flow Planning 137


With these separate issues that affect budgeting out of the way, the household budget can be constructed by following the steps.

Establish Budgeting Goals People may have a variety of goals in establishing a budget. These include targeting sav- ings for a particular expenditure such as a new home entertainment system, vehicle, or vacation. On the other hand, savings may be needed for larger investment purposes, such as the down payment on a home or retirement. However, often a budget is established be- cause the household is in a negative cash flow situation and debt is accumulating. The goal then is to reverse the cash drain and repay the debt. Whatever the immediate goal, the objective of the budget is to ensure that the household generates enough cash to meet its operating needs and over time to provide resources for emergency funds if current assets are insufficient. Finally, by providing hard numbers to household members, the budget can help to reduce inefficient spending.

Decide on the Budgeting Period Budgets can be made weekly, bimonthly, monthly, or annually. The period can follow the natural income and spending cycle, which can be linked to how often a paycheck is paid and when bills are paid. Many people pay bills on a monthly basis. For review purposes, this period of time represents a balance between too frequent and too little examination of actual versus intended results.

Calculate Cash Inflows Cash inflows for budgetary purposes for working people are typically the amounts re- ceived from paychecks. Monies received from investments and nonrecurring sources should be displayed in a separate section or otherwise noted. The segregation of sources of cash is significant because, for active workers, the measure of savings for the period is often based on job-related inflows only. The cash from investments is for a separate pur- pose, and including nonrecurring inflows can distort the figures. To simplify matters, after-tax inflows received from paychecks often are used. Of course, when a person in the household retires, investment principal and income payments should be incorporated as a primary source of revenues. Care should be taken to include anticipated raises in salary and increases in any Social Security payments.

Project Cash Outflows Outflows should be separated into nondiscretionary and discretionary items. Key catego- ries should be separately stated. (See Chapter 5.) To have accurate projected amounts, economic status from the checkbook or software should be used as a guide for past figures whenever possible. When that is not possible, a significant miscellaneous category should be used for projections for unanticipated expenses, including those for unforeseen circumstances. A typical breakdown of expenses is provided in Table 6.1.

Compute Net Cash Flow Net cash flow is simply projected cash inflows minus projected cash outflows. If invest- ment income and nonrecurring items have not been separated, adjustments should be made to get a fairer comparison. The resultant figure should be net cash flow after adjustments, the amount that truly represents a household’s cash generated during the period.

138 Part Two Ongoing Household Planning

Compare Net Cash Flow with Goals and Adjust At this point, projected cash flow figures should be compared with goals. When the figures show a shortfall, the household must determine how to eliminate it. Basically, there are three ways to do this: find additional income, for example, by working overtime; cut back costs, which is the most common way; or change goals. Alteration in goals—say, by post- poning savings—can, of course, undercut the reason for establishing the goal.

Review Results for Reasonableness and Finalize the Budget This step assesses the reasonableness of projections. Do they seem realistic? Do they take into account inevitable nonrecurring expenses? The outcome may be an adjustment in projections and, in some instances, more cutbacks in expenses. At this point, the budget can be finalized.

Compare Budgeted with Actual Figures Comparing actual with projected results is an important part of the budgeting process. Results seldom come out exactly as projected. When there are differences, the reasons must be ascertained. Four common reasons for differences are impulse purchases, income that differs from projections, unusual occurrences, and gifts. The insights developed as a result of this step should be incorporated in future projections. For example, a figure for nonessential purchases may be added to future expenditures.


Using financial ratios is a way to gauge the current state of the household’s assets and operating activities. Frequently, figures from both the balance sheet and cash flow state- ment are used to develop the ratios. Comparisons are made with absolute standards of good performance and with relative results for that particular household over time.

Example 6.3 Len wanted to know whether he was saving enough money. He calculated his current savings as a percentage of total income and found that it was 6 percent. His financial planner had said that for someone Len’s age and with his goals, 10 percent seemed appropriate. Len then cal- culated his savings rates over the past two years and found they were 3 percent and 5 percent. Although Len was pleased that his savings rate was rising over time, he decided to redouble his savings efforts to reach the 10 percent standard.

TABLE 6.1 Average Annual Household Expenditures

Source: Adapted from Bureau of Labor Statistics, Consumer Expenditures 2013, http://www. bls.gov/cex/csxann13.pdf

Complete Reporting of Income

Total Complete Lowest Middle Highest Item Reporting 20 Percent 20 Percent 20 Percent

Average annual expenditures 100% 100% 100% 100% Food and beverages 14 17 14 12 Housing 34 40 35 31 Apparel and services 3 3 3 3 Transportation 18 15 19 17 Healthcare 7 8 8 6 Entertainment 5 4 5 5 Personal insurance and pensions 11 2 8 16 Other* 9 10 8 10

* Other includes personal care products and services, reading, education, tobacco products and smoking supplies, miscellaneous and cash contributions.

Chapter Six Cash Flow Planning 139

Now we take a closer look at selected liquidity ratios and operating ratios. (For exam- ples, see the ratios provided to Dan and Laura on page 181.) In Chapter 7 we describe ratios that have to do with liabilities.

Liquidity Ratios Liquidity, as we have said, is the amount of cash and the ability to turn assets into cash with relative ease and without loss of principal. We next consider two ratios: the current ratio and the emergency fund ratio.

Current Ratio The word current generally refers to actions to be taken in the present year. It is here that day-to-day assets and liability transactions reside.

Current ratio = Current assets

Current liabilities

The current ratio measures your present resources available to pay current debts. This ratio should exceed 1.0×, which means that current assets are higher than current liabilities. Having a lower ratio could represent an inability to pay debts when due. The ability to bor- row money through credit card purchases and to delay payment on existing card debt has somewhat reduced the concern of running out of cash to pay current liabilities.

Emergency Fund Ratios The emergency fund ratio measures how many months of living expenses can be supported by available liquid assets such as money market funds and savings accounts.

Emergency fund ratio = Liquid assets

Total monthly household expense

Total emergency household expenses include all expected cash outflows, both nondiscre- tionary and discretionary outlays. Often a ratio of at least 3.0 × is called for, signifying that three months of cash or perhaps other somewhat liquid, less volatile securities are available. But, as we discussed, there is no hard-and-fast rule as to amount. The higher the uncertainty for income and expenses, the higher is the ratio.3

Operating Ratios Operating ratios measure the overall costs of the household and its components as a percent of total income. We are interested in how these percentages change over time.

Current ratio = Current assets

Current liabilities

Nondiscretionary Cost Percentage The nondiscretionary cost percentage provides the proportion of day-to-day overhead costs to total revenues. When this percentage changes significantly from year to year, we would

3 When a decline in income of extended duration is a significant possibility, marketable securities such as stocks and bonds could be included in the numerator along with liquid assets. Households with expected declines in real income were more likely to have adequate emergency fund reserves. Also, financial planners on average recommended three months of living expenses be saved. See Y. Regina Chang, Sherman Hanna, and Jessie X. Fan, “Emergency Fund Levels: Is Household Behavior Rational?” Financial Counseling and Planning Journal 8, no. 1 (July 1997): 47–55; Janine Scott, Duncan Williams, John Gilliam, and Jacob P. Sybrowsky. “Is an All Cash Emergency Fund Strategy Appropriate for All Investors?” Journal of Financial Planning 26, no. 9 (2013): 56–62.

140 Part Two Ongoing Household Planning

look at the individual components of nondiscretionary costs to find the reason. Our goal should be to reduce the nondiscretionary percentage over time, which can represent a mea- sure of efficiency in household activities.4

For example, telephone (including smartphone) expenses may be considered nondiscre- tionary because household members need to communicate for career and social purposes. These outlays might fall into a utilities category in a budget, such as Dan and Laura’s. Finding a better phone plan can cut the costs, absolutely and as a percentage of total out- lays. The lower the percentage, the higher is the amount available for discretionary costs and savings and investment.

Nondiscretionary cost percentage = Total nondiscretionary costs

Total income

Discretionary Cost Percentage Discretionary costs represent the benefits of household efforts. Assuming appropriate savings for the future, the lower the percentage of household fixed costs and the higher the percentage of optional expenses, the higher are the household’s satisfaction and standard of living.

Discretionary cost percentage = Total discretionary costs

Total income

Total Operating Percentage

Total operating percentage = Total nondiscretionary costs + Total discretionary costs

Total income

The total operating cost percentage5 provides an overall measure of day-to-day household expenses. The percentage indicates how much of household revenues are being spent to- day on nondiscretionary and discretionary costs. It can serve as a control on expenses and as a guide to the amount available for capital expenditures and savings; the lower the per- centage, the higher is the amount available for these items.6

Payout Ratio When applied to households, the payout ratio views discretionary outlays as a kind of dividend. As with a business, the household must decide how much of available cash flow to pay out today for enjoyable activities and how much to save.

payout Discretionary

percentage =

Discretionary expenses + Discretionary capital expenditures Cash flow before discretionary expenses

Cash flows before discretionary expenses indicate the amount of money available about which household members have choices. The discretionary payout percentage combines dis- cretionary expenses and capital expenditures for leisure items such as a television. It mea- sures the percentage of available cash flow that is actually expended on all leisure outlays.

4 Unless the increased overhead costs come from a pleasure-producing commitment such as interest on debt used to finance a vacation home. 5 The formulas exclude capital expenditures. To include them could distort year-to-year comparisons. In multiyear groupings of cash flow statements, however, these capital items should be included. A case could be made for incorporating an imputed expense based on the rental value during the year or per- haps including the depreciation in the value of the capital expenditures each year in the expense ratio based on the useful life of the asset, but that would be closer to an accounting or economic as opposed to a finance approach. 6 As well as for paydown of debt.

Chapter Six Cash Flow Planning 141

College Age • Develop an overall approach to spending consistent with your own or your parents’ ability and desire to pay.

• If you are really pressed, think about a part-time job.

• If you are stressed over money, try some new activities and share your concerns with a friend.

• Attending college is a formative time; make sure you are “forming” and enjoying it.

Twenties • If you are single and have a good job, start a meaningful savings plan.

• Begin an emergency fund that you won’t touch unless you are in dire circumstances.

• Try to emphasize the outlays on capital expenditure items such as buying a home or get- ting a master’s degree.

Thirties • If you are married with children, don’t be surprised if spending decisions are restrictive; they will be getting better.

• Build up your emergency fund. Many people attempt to build it to 6–12 months of living expenses.

• Think about making a budget and review it every year. The exercise itself is likely to make you more efficient.

Forties • Free cash flow may be getting easier to develop, just in time for more attention to pension contributions.

• Do a “mid-course evaluation” and if savings are truly materially lower than expected, make some changes.

• Place savings in separate “buckets” arranged by reason for maintaining each bucket.

Fifties • You should have more free cash flow and it should be nearing a peak. If that’s not the case, make sure the problem does not result from overspending.

• Shift into a retirement planning mentality if you haven’t done so already.

• Take tangible actions for increasing savings, which can often be done without a current decline in your standard of living. For example, if you have been paying for food, clothing, and education for your children and that cost is coming to an end, save that same amount every month for yourself.

Sixties • Household cash flow should be strong prior to retirement, so save at least part of the extra money for your future retirement needs.

• Note that retirement expenditures are often lower than expected because you now have time to focus on more efficient spending plans including buying on discount days for senior citizens.

Seventies and Beyond • Keep spending on an even level.

• Don’t anticipate too much of a saving from lower recreational experiences because your medical and physical assistance costs may rise.

Life Cycle Planning Cash Flow Planning

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142 Part Two Ongoing Household Planning

The higher the payout percentage, the lower is the percentage going into traditional ef- ficiency-enhancing capital outlays for the household and other forms of investment, such as mutual funds. A high payout percentage can reflect a desire for a higher standard of living today as opposed to improved household efficiencies and a higher, more secure standard of living in the future.

Savings Percentage Savings represents the amount set aside for expected outcomes such as retirement, emer- gencies, and improvements in the household’s future standard of living.

Gross savings percentage = Net cash flow + Targeted savings + Change in debt

Total income

The savings percentage7 indicates the total combined percentage of total income that is being put away for future needs. The amount expended to pay off debt is considered sav- ings whereas an increase in debt reduces the savings rate.8 The objective for saving depends on individual circumstances and goals, but saving 10 percent of the household’s gross income is often a desirable rule of thumb.

7 Employer contributions to retirement plans would be added to savings figures. 8 Amounts for certain types of capital expenditure, such as those that increase the value of investment property, may be considered savings as well. One example might be the renovation of a kitchen or bathroom that, in particular, can enhance the value of a house.

Back to Dan and Laura CASH FLOW PLANNING At our next meeting, it became even clearer that I was dealing with two different spending philosophies. Dan was more frugal, preferring to save to have monies available for future contingencies and to begin to fund retirement. Laura said her parents never gave having enough money a thought and everything worked out. Laura enjoyed taking trips to the regional mall to purchase fairly expensive clothes for Brian and herself. Now that Brian was around and she wasn’t working, she also spent more time at the health club. Both she and Dan ate out and spent considerable money on entertainment, which created high babysitting bills as well. The combination of the lack of Laura’s salary, higher living expenses, and their intent not to touch the investments had produced the cash shortfall and the $20,000 in credit card debt. I noted that, in effect, they were operating on two tracks with Dan saving money at the same time that Laura was spending it. Both knew the system had to change and invited my comments on how to do this. When I told them that it was important to determine when Laura might go back to work, she replied, “In five years.” Just before they left, Laura smiled and said sweetly that she would have difficulty sub- jecting her spending to a fixed written budget. Then, after thinking about it for a minute, she said unless it was absolutely necessary.

Here’s the advice I presented to them: Cash flow planning is the scheduling of cash outflows to meet near and long-term resources. It is often at the heart of a financial plan. Generally, without cash flow, you can’t meet household goals. Cash flow planning is particularly important for couples like yourselves. You have to establish the structure to live within your means. That entails

Chapter Six Cash Flow Planning 143

saving enough money to fund your goals: these extend from buying a home to educating your current and child and anticipated children, to retirement. When cutbacks are called for, as they are here, it’s important to retain those expenditures that each of you believes are particularly important for an enjoyable life. You began running a cash flow deficit before borrowing this year after Laura stopped working. As you are aware, these deficits have to end. They must be replaced by saving. There are a number of areas that appear to be particularly suited to being examined and perhaps cut. Clothing is treated as an overhead item called nondiscretionary expenses. However, it’s clear that you spend more than is necessary to dress yourself adequately. In fact, the act of shopping and finding interesting items is an enjoyable leisure pursuit. Despite that obser- vation, to simplify things, I’ve included all clothing outlays under the nondiscretionary category. Vacations and eating out are true discretionary expenses. Note that one year ago, all these expenses were considerably lower, which suggests that they could be reduced without dramatically affecting your lifestyle. Laura, I believe cutbacks are absolutely necessary for you to realize your goals. In cer- tain cases, the figures even with cutbacks are not that different from those outlays you had last year. I’ve attached a schedule of cutbacks. Notice that they are focused on delivered food, clothing (even though they are placed entirely under the nondiscretionary column for convenience purposes, both of them have a discretionary component), recreational and personal outlays, and vacations. If there’s an objection to any area of cutbacks, substitute another that provides the same amount of savings.

Schedule of Cutbacks


Before Plan After Plan


Groceries $ 5,800 $ 6,800 Delivered food 3,000 0

Total food 8,800 6,800 Dan’s clothing 4,000 3,000 Laura’s clothing 7,000 5,000 Baby’s clothing 2,500 4,000

Total clothing 13,500 12,000


Recreation/entertainment $ 6,000 $ 3,000 Personal 6,500 4,000 Vacations 8,000 4,000

Total savings $13,000*

* This figure is the sum of the cutbacks as represented by the differences between the After Plan and Before Plan columns.

The result of these efforts will be to place you on a better financial footing, including an ability to continue making pension payments. I recommend that, as a structuring mechanism and to put you in the “savings habit,” you do the following:

1. Establish separate savings accounts for anticipated educational needs and contingencies. Placing these in separate “buckets” for each item can better relate savings to a tangible goal. It also can make you more reluctant to withdraw monies for nonessential needs.

144 Part Two Ongoing Household Planning

You are fortunate that Laura’s parents have volunteered to gift you $65,000 provided it is used for the down payment on a home. One bucket down already.

2. You can begin funding these buckets immediately out of your marketable investments, which now total $137,000. With Laura not working, you are projected to run a deficit of close to $90,000 over the next five years. We recommend that you set aside $90,000 in a bucket to cover those deficits. The remaining marketable securities can be used to create an emergency fund, begin a college savings bucket, or fund 401(k)/IRA contribu- tions each year because funds won’t be available from Dan’s salary.

3. Write a check to each account at the beginning of each of Dan’s bimonthly pay periods. We project, however, that you won’t be able to begin doing so until 2020 Not going be- yond the remaining amounts in your checking account can be an important structuring tool.

4. Be aware of your spending habits, particularly in the area discussed. However, as long as you don’t do it too often, reward yourself occasionally with a spending “treat” when you have accomplished savings-spending goals for a period of time.

Recognize that your cash flow concerns should ease considerably once Laura goes back to work. The cash flow statement is attached. It includes the purchase of a home next year. As I’ll detail later under nonfinancial investments, I believe the home to be an attractive investment now. I’ve included other capital expenditures that we’ll discuss in a separate meeting. This cash flow statement is likely to be revised as your other financial goals come into better focus. However, for now, notice the difference in cash flow between the before and after cutbacks columns. Finally the statement includes projections for seven years as opposed to the three or four years I usually display. That is done for you to see the difference in cash flow begin- ning in year 6 when Laura goes back to work.

Projected Cash Flow Statement

2015 2015 2016 2017 2018 2019 2020 2021

Operating Activities Before Plan After Plan


Total compensation $100,000 $100,000 $110,000 $121,000 $133,100 $146,410 $240,882 $259,352 Total investment income 4,000 4,000 4,000 4,000 4,000 4,000 4,000 4,000 Total other income 0 65,000 0 0 0 0 0 0

(gift from parents)

Total Income $104,000 $169,000 $114,000 $125,000 $137,100 $150,410 $244,882 $263,352


Nondiscretionary Rent $15,000 $15,000 $0 $0 $0 $0 $0 $0 Property tax 0 0 2,500 2,575 2,652 2,732 2,814 2,898 Upkeep and insurance 2,000 2,000 3,000 3,090 3,183 3,278 3,377 3,478 Utilities 3,600 3,600 3,708 3,819 3,934 4,052 4,173 4,299 Furnishings/moving 1,000 1,000 12,530 1,061 1,093 1,126 1,159 1,194 Mortgage interest 0 0 17,219 17,066 16,902 16,727 16,538 16,336

Total housing 21,600 21,600 38,957 27,611 27,764 27,914 28,061 28,205 Insurance 2,050 5,950 7,090 7,183 7,278 7,377 7,478 7,582 Professional fees 0 4,000 1,030 1,061 1,093 1,126 1,159 1,194 Child care (babysitter) 3,000 3,000 3,090 3,183 3,278 3,377 6,956 7,164 Food 8,800 6,800 7,004 7,214 7,431 7,653 11,361 11,702 Clothing 13,500 12,000 12,360 12,731 13,113 13,506 13,911 14,329 Health care (out of pocket) 1,350 1,350 1,648 1,697 1,748 1,801 1,855 1,910

Chapter Six Cash Flow Planning 145

Projected Cash Flow Statement

2015 2015 2016 2017 2018 2019 2020 2021

Operating Activities Before Plan After Plan

Transportation 4,500 4,500 5,408 5,570 5,737 5,909 9,564 9,851 Credit card interest 0 0 0 0 0 0 0 0 Income and payroll 25,080 25,080 23,917 27,209 30,835 36,956 71,900 78,410

Total nondiscretionary $79,880 $84,280 $100,503 $93,458 $98,277 $105,617 $152,245 $160,347

Cash Flow before $24,120 $84,720 $13,497 $31,542 $38,823 $44,793 $92,636 $103,005 Discretionary Expenses Discretionary Recreation/Entertainment $6,000 $3,000 $3,090 $3,183 $3,278 $3,377 $6,956 $7,164 Personal 6,500 4,000 4,120 4,244 4,371 4,502 7,535 7,761 Vacations 8,000 4,000 4,120 4,244 4,371 4,502 9,274 9,552 Gifts and charitable 2,000 2,000 2,060 2,122 2,185 2,251 2,319 2,388

contributions Hobbies 2,750 2,750 2,833 2,917 3,005 3,095 3,188 3,284 Total discretionary $25,250 $15,750 $16,223 $16,709 $17,210 $17,727 $29,272 $30,150 Cash Flow from ($1,130) $68,970 ($2,726) $14,833 $21,613 $27,066 $63,365 $72,855


Capital Expenditures

Purchase of home $0 $0 $250,000 $0 $0 $0 $0 $0 Total educational expenses* 2,666 2,666 24,924 26,046 27,234 28,494 1,458 1,170 Household maintenance† 1,000 31,000 1,030 1,061 1,093 1,126 1,159 1,194 Leisure 2,000 2,000 2,060 2,122 2,185 2,251 2,319 2,388 Total capital expenditures $5,666 $35,666 $278,014 $29,229 $30,513 $31,870 $4,936 $4,752 Cash flow before ($6,796) $33,304 ($280,740) ($14,396) ($8,900) ($4,805) $58,429 $68,103

financing activities

Financing Activities

Total repayments‡ $6,463 $23,463 $5,783 $6,162 $6,567 $6,998 $7,458 $7,948 Mortgage 0 0 (237,500) 0 0 0 0 0 Additional credit card debt 0 0 0 0 0 0 0 0 Total financing activities $6,463 $23,463 ($231,717) $6,162 $6,567 $6,998 $7,458 $7,948 Cash Flow ($13,258) $9,842 ($49,023) ($20,558) ($15,466) ($11,802) $50,972 $60,156 Targeted for retirement $0 $0 $0 $0 $0 $0 $50,000 $60,000 Targeted for college 0 0 0 0 0 0 0 0 Net Cash Flow ($13,258) $9,842 ($49,023) ($20,558) ($15,466) ($11,802) $972 $156

* Includes expenses for Laura’s master’s degree program and student loan interest. † Includes $30,000 for Dan’s new car. ‡ Includes mortgage, student loan, and credit card principal.

Finally, I’ve provided your financial ratios. They point to a fairly weak cash position and weak savings ratio. Although the gross savings of 20 percent is high, it is due to the parental contribution. After our discussions, this weak cash flow situation shouldn’t be a surprise. However, following my advice will have a substantial positive effect on these ratios.

Current ratio = Current assets

Current liabilities

= 3,000

27,000 = 0.11

Emergency fund ratio = Liquid assets

Total monthly household expenses

146 Part Two Ongoing Household Planning

= 37,000

8,336 = 4.44

Nondiscretionary cost percentage = Total nondiscretionary costs

Total income

= 84,280


= 0.50 × 100% = 50%

Discretionary cost percentage = Total discretionary costs

Total income

= 15,750


= 0.09 × 100% = 9%

Total operating percentage = Nondiscretionary costs + Discretionary costs

Total income

= 100.030


= 0.59 × 100% = 59%

Discretionary payout percentage = Discretionary expenses +

capital Discretionary


Cash flow before discretionary expenses

= 17,750


= 0.21 × 100% = 21%

Gross savings percentage = Net cash flow + Targeted saving + Change in debt

Total income

= 9,842 + 0 + 23,463


= 33,305


= 0.20 × 100% = 20%

College Student Case Study and Review: Amy and John CASH FLOW PLANNING Cash flow is the heartbeat of an individual’s activity. Without positive cash flow, normal ac- tivities can’t continue. Both Amy and John understood. They said their cash flow had turned negative because their parents weren’t able to fund as much of their college costs as originally planned. As stepsiblings, I was glad to see they weren’t competing with each other for their parents combined income. I mentioned that a positive cash flow—savings—is normally what was desired but wasn’t possible because they were investing in their future at school.

Chapter Six Cash Flow Planning 147

I mentioned that there were many reasons for savings including:

1. Pure life cycle. For use over their remaining lives, particularly during retirement.

2. Investment. To grow assets.

3. Down payment. To segment for future purchase of an asset.

4. Precautionary. To save for an emergency.

5. Improvement. To sacrifice today for a higher standard of living in future.

6. Independence. To become financially independent.

7. Bequest. To leave for others.

8. Hoarding. To savor money with no intention of using it.

Budgeting is the method of allocating future cash flows generally with the idea of effi- ciently allocating it. Informal budgeting involves less detail with a broad net cash flow objective. Formal budgeting involves setting up a detailed budget for major or all catego- ries: Its goals are to prioritize outlays, reduce or eliminate impulsive purchases, avoid be- ing caught short of cash, and save enough for future needs. Ways of increasing savings include:

Structural Approach

• Treat savings as just another expense.

• Have money wired directly to a savings account.

• Develop a budget.

Buckets Approach

• Put savings in separate accounts for specific uses to make it more difficult behaviorally to make unplanned withdrawals.

• Eliminate the option to spend. Put money in accounts that have penalties or other diffi- culty for taking it out.

• Reduce temptation. Stay away from shopping as a leisure activity. When possible, leave credit cards at home when you shop.

The steps in household budgeting include:

1. Establish goals. Place a total expenditure limit or total savings goal for a specific future expenditure or for general future use.

2. Decide on budgeting—period.

3. Calculate cash inflow.

4. Project cash outflows.

5. Compute net cash flow.

6. Compare net cash flow with goals and adjust.

7. Review results for reasonableness and finalize the budget.

8. Compare budget with actual income and expenses.

Financial Ratios Ratios are used to gauge the state of current household assets and operating activities. They can be compared with industry standards or with the household’s own ratios over time to determine whether they are getting stronger or weaker. (The financial ratios are given in a textbook I gave them.)

148 Part Two Ongoing Household Planning

Summary Along with financial statement analysis, cash flow planning is often performed near the beginning of the financial planning process. Both help to set the tone for other areas to come.

• Available cash flow makes financial planning possible.

• Savings for future needs can be difficult for some; budgeting techniques can help bring about acceptable savings rates.

• A variety of methods can facilitate savings, including a simple structural approach pro- viding motivation, eliminating an option to spend, reducing temptation, and minimizing discomfort.

• Financial ratios can provide an objective assessment of specific segments of a house- hold’s financial condition.

Key Terms budgeting, 133 cash flow planning, 132

financial ratios, 138 household budget, 133

purchasing power, 135 purchasing power risk, 135

investopedia.com Investing Glossary The site provides a general online investment dictionary. It also features financial ratio definitions as well as articles and tutorials regarding cash flow planning.


Questions 1. What is cash flow planning? 2. Why is cash flow planning so important?

3. List five reasons for saving.

4. Why do some people have difficulty saving?

5. Provide five methods for helping people to save.

6. Why do people construct a budget?

7. What is a liquidity substitute? When should it be used?

8. Why are financial ratios important?

9. Chris’s current liabilities exceeded his current assets. He said not to worry; he could use his credit card if he needed extra funds. What do you think of this practice?

10. Maya had a low nondiscretionary cost percentage and a high discretionary one. Is that good or bad? Explain.

11. What are the reasons that a person’s gross saving percentage may be low, while his or her net cash flow may be high?

Problems April made $50,000 in year 1 and $60,000 in year 2. She had the following yearly outflows:6.1

Year 1 Year 2

Nondiscretionary $25,000 $27,000 Discretionary 10,000 12,000 Capital expenditures 5,000 13,000 Debt repayment 0 6,000

Calculate April’s operating cash flow and net cash flow for each year.

Chapter Six Cash Flow Planning 149

Jamie had the following figures over the past four years.6.3

Using the following statistics, calculate Jackson’s current and emergency fund ratios.6.2

Current assets $2,000 Current liabilities 1,000 Liquid assets 8,000 Marketable securities 20,000 Monthly household $6,000

Nondiscretionary Cost Discretionary Cost Total income

Year 1 $56,000 $7,000 $60,000 Year 2 54,000 8,000 60,000 Year 3 52,000 9,000 60,000 Year 4 $50,000 $10,000 $60,000

a. Calculate the nondiscretionary cost percentage and what the change in the ratio demon- strates over time.

b. Calculate the discretionary cost percentage and what the change demonstrates over time.

c. Calculate the total operating cost percentage and what the change demonstrates over time.

d. Indicate what your recommendation might be.

Sharon had gross income of $120,000 and nondiscretionary expenses of $32,000. She also had discretionary expenses of $10,000, and her capital expenditures on leisure items were $5,000. What is her discretionary payout percentage?

Abby had the following statistics. Calculate the gross savings percentage.



Net cash flow $6,000 Nondiscretionary expenses 35,000 Discretionary expenses 8,000 Targeted retirement savings 5,000 Repayment of debt $2,000

Robert Smith asks for your help in preparing his cash flow statement. He tells you that his salary before taxes is $250,000 and that he has no mortgage on his home. Which of the following statements is true about Robert’s cash flow statement?

a. The value of the home would be an income source since there is no mortgage.

b. The value of the home would be an asset.

c. The taxes on his salary would be a liability.

d. The taxes on his salary would be an expense.

Six months ago, a client purchased a new bedroom suite for $6,500. For purposes of pre- paring accurate financial statements, this purchase would appear as a(an)

1. use asset on the client’s net worth statement.

2. investment asset on the client’s net worth statement.

3. variable outflow on the client’s historic cash flow statement.

4. fixed outflow on the client’s cash flow statement.

a. (1), (2), and (3) only

b. (1) and (3) only

c. (2) and (4) only

d. (4) only

e. (1), (2), (3), and (4)



CFP® Certification Examination Questions and Problems

150 Part Two Ongoing Household Planning

Case Application SAVINGS AND THE CASH FLOW STATEMENT Richard came in with his cash flow statistics and very helpful notes on projections. His list included


Salary $100,000 Investment income $8,000

Outflows Home related $20,000* Food 5,000 Clothing 8,000 Health care 6,000 Transportation 2,000 Personal 3,000 Recreation 4,000 Cars, entertainment 9,000 Hobby 1,000 Gifts and charitable contributions 2,000 Insurance 6,000 Taxes 26,000†

* Includes mortgage interest and principal payments, property taxes, home maintenance, and home insurance. † Net of $3,000 allowable tax loss with $191,000 tax loss carryforward on original 200,000 loss.

He said to assume that his salary will rise 6 percent a year, and his investment income is 11 percent a year (the investment loss came a year ago). His expenses should rise 3 percent a year except for medical, which will grow at a rate of 6 percent yearly, and taxes, which will grow at about 7 percent a year. Richard said he was not worried about the losses taken. He would make them up, but Monica insisted that they save additional monies. He wanted to know what I recommended to help him save. He said he knew Monica was secretly putting away part of her household money into an account in her own name.

Case Application Questions 1. What observation do you have about the couple’s expenditures?

2. What might the conversation above tell you about Richard?

3. What might Monica’s actions tell you about both Monica and Richard?

4. What recommendations would you have to help them save more?

5. Construct their cash flow statement for this year and the next two years.

6. What do the future cash flow figures indicate?

7. Complete the cash flow section of the plan.


Chapter Goals

This chapter will enable you to:

• Develop debt strategies.

• Understand the many facets of debt.

• Calculate and comprehend the rates charged on loans.

• Identify the factors that enter into selecting credit.

• Evaluate a fixed- versus a variable-rate mortgage.

• Specify the advantages and disadvantages of a credit card loan.

• Interpret financial ratios related to debt.

Dan hated the thought of debt, yet here he was owing $20,000 on credit cards. Laura was very blasé about the borrowings. Not only financial issues were involved in our delibera- tions. Their differing points of view on debt were affecting their personal relationship.

Real-Life Planning

The advisor faced a new situation. Instead of presenting the results of his analysis to a couple in the privacy of his office, he was to broadcast it to millions of people. A major network had contracted with him to provide a financial plan for a young couple. The results would be taped and televised on a newsmagazine show in prime time. The couple agreed to have their financial situation aired, and the taping took place in the advisor’s office. When the advisor analyzed the couple’s financial situation, it became apparent that it was dominated by debt. The husband and wife both had comfortable jobs with moderate incomes. There was nothing moderate about their credit card debt, however. It had been climbing steadily and now stood at almost six months’ combined salary for them. The ad- visor remembered what one financially unsophisticated college graduate called her student loan, which had a 7 percent rate. She had called it an “evil loan” because it continued to climb in the amount outstanding each year even though she had not borrowed any more money. If unpaid, this couple’s loan at an 18 percent rate would climb much more rapidly, doubling in four years. When questioned about the use of credit cards, the woman said she wanted to live the “American dream.” She said she was going to make a large amount of money in a key ex- ecutive position. The spending beyond her current means was just a down payment on her future lifestyle. The advisor thought about her comment. On the one hand, it reflected a valid economic approach. It was consistent with Modigliani’s life cycle theory of spending and saving,

Chapter Seven


152 Part Two Ongoing Household Planning

indicating people’s desire to even out their standard of living over their lives. On the other hand, there was no indication that either person was on a fast track because recent raises had been fairly modest. When asked in a follow-up interview about the modest raises and in- creasing debt, the woman repeated her comment about the “American dream” and expressed a great confidence in her ability to become important. When questioned separately, the husband, who had his own credit cards and spending pattern, merely said he wasn’t worried. The advisor had seen this pattern of spending and debt before, and it often led to financial difficulty and even bankruptcy. Modigliani or not, he decided to present the findings in a sober way. At the taping he did so. He mentioned the amount outstanding and the potential for bank- ruptcy, and then outlined a method of gradually clearing their debt. It turned out that neither person was aware of the debt the other had amassed. Each literally pointed a finger at the other as the source of blame. (The producer told the advisor at the time that everyone in the room knew that this dramatic scene would definitely be aired.) Despite that animated moment, the advisor felt the woman was not buying into that part of the plan’s recommendations. Weeks after the show was aired, the advisor spoke to the woman to find out how implementation of the plan’s recommendations was going. She mentioned she had taken a position as head of an office of a U.S. subsidiary that would take advantage of her bilingual abilities, at five times her former pay. Her debt strategy had paid off. The “American dream” had come true. The debt wasn’t a problem after all. The advisor thought about his cash flow recommendations. Were they inappropriate? He decided the answer was no. For every client like her, there were ten others who needed to hear the sobering advice. Perhaps he had failed to consider the ability of the woman to utilize the power of a nationally televised show to market herself. In any event, it was enjoyable to see that the “American dream” was alive and well. Of course, not every such story has a happy ending. When things don’t work out so well, the American dream can turn into a nightmare. In the early years of this century, home prices rose at an unprecedented pace. Lenders became lax in screening borrowers because mortgages secured by appreciating houses seemed like safe loans, and many people found that they could buy expensive homes with little or no money down. The downside to a low- or no-down payment arrangement, of course, is that borrowers had to take on large amounts of debt. When the housing market declined sharply, trigger- ing the recession of 2008–2009, unemployment soared and many of those highly leveraged homeowners saw their incomes sink. Keeping up the payments on a $200,000 or $300,000 mortgage became impossible or at least impractical, if such homes now were worth, say, only $150,000 or $250,000. Countless homeowners had to strain to make their mortgage payments or else default on the loan and thus impair their credit rating. Suddenly, the world became aware of the concept of a “short sale,” in which the only way to sell an unaf- fordable home was to accept a bid for less than the mortgage balance, assuming you could get permission from the mortgage holder to sell at the depressed price. You might even owe income tax on any forgiven debt, although the Mortgage Forgiveness Debt Relief Act provided relief to some sellers. It’s true that buying a home with borrowed money can be a winning move. If you buy a $200,000 home with $40,000 (20 percent) down, for example, a $50,000 (25 percent) increase in property value over time will be a 125 percent return on your cash down payment. However, the flip side of using leverage is that unfavorable events can have negative consequences.


Debt represents many things. To financial planners it often represents risk. Too frequently they see abusive use of credit leading to financial difficulties. They recommend that debt be limited to investment items such as the purchase of a home.

Chapter Seven Debt 153

To consumers, debt represents opportunity. Borrowing money allows people to pur- chase items they don’t have the current cash resources to buy. At its extreme, it can sym- bolize a preference for pleasure-producing goods today over consequences for the future—in other words, overspending. This chapter, then, is about the many faces of debt. It considers how debt should be reviewed, when it is good or bad. It provides ratios that indicate acceptable financing practices. It details how to obtain and maintain proper credit and calculate its costs, and it discusses the advantages and disadvantages of various financing alternatives. The chapter also will explain what to do when in financial difficulty and includes an evaluation of bankruptcy. All these topics can be incorporated under the broader heading of debt management. Under household finance, the household enterprise can have spending needs that exceed its current resources. Borrowing presents a ready source of cash flow. Debt management leads to the proper utilization of financing alternatives for efficient household operations. Just as there is an appropriate amount of debt in a business capital structure, the household must decide how much debt it wants to contract for. The decision includes not only return alternatives but the household’s tolerance for risk. Borrowing helps by providing funds to raise homeowners/standard of living today or to make investments such as those for the house and its possessions or to contribute to the financing of a business. As you can see, debt is used for many purposes. It can allow homeowners to enjoy a product that they could not yet afford to purchase outright. It may make it possible to balance the peaks and valleys in the homeowners’ spending pattern within each year such as when they borrow to fund high annual vacation expenditures. It also may help homeowners to even out their life cycle style needs or enable them to make an outlay for a significant capital expenditure or other investment opportunity. Borrowing theory is presented in Appendix I of this chapter. In sum, borrowing is a tool that we use to accelerate consumption or to help finance investments. Our financial planning objective is to use debt wisely, selecting the lowest- cost source and proper amount of borrowing consistent with our goals and tolerance for risk. In order to do so, we will first examine risk more closely.


As our preceding discussion indicates, debt is often associated with risk. The higher the debt, the higher is the household’s risk. People who have too much debt are said to be overleveraged. Few recognize that there are two types of leverage and two types of risk: operating and financial. Although much time is spent on this subject for business, it is often neglected for households. By explaining and distinguishing between operating and financial factors, we can better understand household risk and be more effective in planning for it. Operating risk arises from uncertainties in connection with household activities. People may spend considerable time and resources investing in a job only to find that the company they work for has limited growth prospects. The washing machine that a house- hold invested in may turn out to require constant repairs. The house purchased may decline in value. In contrast, financial risk comes from the amount of debt outstanding relative to an individual’s assets. If debt rises from 10 percent to 50 percent of total assets, financial risk has increased substantially. Although frequently used to refer only to financial leverage, leverage can actually be separated into two components: operating and financial leverage. Operating leverage is the degree to which people have fixed costs in their budgets that come from household operating functions. The higher the percentage of their nondiscretionary costs—high fixed

154 Part Two Ongoing Household Planning

costs that cannot easily and quickly be cut back—the higher their operating leverage. These nondiscretionary costs are ongoing obligations.1

When households have high fixed costs, a modest increase or decrease in their income can have a material impact on their free cash flow. For example, enrollment of a child in an expensive private college is a fixed cost that could give a household significant operating leverage. A planned outlay on an expensive vacation would not increase its leverage be- cause its cost could easily be cut back. The higher fixed costs are as a percentage of total costs, the higher is the operating leverage. Operating leverage in business and investing is commonly illustrated with the example of a gold mine.

Example 7.1 A mine can bring an ounce of gold to market at a total cost of $1,000. Assume that gold sells for $1,200 per ounce. The profit would be $200 an ounce. A $100 increase in the price of gold to $1,300 would be a 8.33 percent increase in revenues ($100/$1,200). The profit is now $300 an ounce. By how much would the company’s profits be affected?

= Current profit − Previous profit

Previous Profit

= 1$300 − $2002


= 50%

Because the company’s profits would rise by 50 percent, its stock price might increase by more than the 8.33 percent increase in the gold price and revenues. Conversely, an 8.33 percent decrease in the price of gold from $1,200 to $1,100 per ounce would drop profit- ability by 50 percent, from $200 to $100 per ounce, and might cause a sharp decline in the stock price. The same principal applies to a household. Assume $3,000 in monthly income and $2,700 in monthly fixed costs, including groceries, utilities, insurance, and so on. A $300 increase (10 percent) in monthly income would double the household’s free cash flow from $300 to $600 per month whereas a 10 percent decline in monthly income would eliminate the household’s free cash flow.


Financial leverage arises from the amount of debt outstanding and its contribution to household fixed costs. The higher the amount of the household’s interest expense and debt repayment commitments, the greater its financial leverage. As with operating leverage, when a household has high fixed financial costs, a change in income can have substantial effects on its free cash flow. For example, a decline in income can put the household in great financial difficulty. Putting debt and financial leverage together, the higher the amount of debt is, the higher the financial leverage is, and the higher the risk is. Financial leverage can increase potential rewards for the household and can allow it to purchase and enjoy the benefits of a car or television set earlier. Many first-time homebuy- ers undertake significant financial leverage by making an expensive purchase of a dwell- ing. For example, 80 percent or more of the purchase price of a house may come from debt and 20 percent or less from personal savings. Should the home subsequently rise sharply in

1 They are treated as such in the pure form of total portfolio management. Capitalized nondiscretionary costs and financial debt are both employed in the intent to move toward the optimal asset allocation.

Chapter Seven Debt 155

price, that financial leverage can enable the member-owners to make a high return on their household investment. In sum, we have illustrated a basic financial principle. Undertaking additional debt has two effects: It not only raises risk but also increases potential returns. We will expand on this risk-return concept in Chapter 10 on financial investments.

Example 7.2 Matthew had no savings and had borrowed $40,000 to purchase new furniture and furnish- ings in his home and to buy a car. His income is $80,000 per year including an $8,000 bonus. In a good year for his company he can double the bonus whereas in a poor year the bonus could be eliminated. Using the following figures, note the change in free cash flow given the same outlays but differing levels of income and indicate his degree of financial and operating leverage.

Expected Good Year Poor Year

Income $80,000 $88,000 $72,000 Nondiscretionary costs* 59,000 59,000 59,000 Discretionary costs 4,000 4,000 4,000 Cash flow before debt 17,000 25,000 9,000 Interest cost 7,000 7,000 7,000 Repayment of debt 8,000 8,000 8,000 Free cash flow $2,000 $10,000 ($6,000)

* Excluding interest.

Matthew has high financial leverage. A 10 percent increase in his income to $88,000 results in five times as much free cash flow: $10,000 versus $2,000. On the other hand, a 10 percent decline in his income could result in a $6,000 deficit and an inability to pay debts when due. The fact that he also has high operating leverage because most of his household costs are nondiscretionary gives him little room to cut back on his lifestyle to meet his debt repayment in the event of a bad year. High operating and high financial leverage could place Matthew in a potentially vulnerable situation.


The interest rate is the cost of borrowed money. In order to make a proper borrowing decision, we need to know the interest rate being charged. To calculate the real interest rate, we must know the time period for the loan and the actual amount of money that is made available. That calculation isn’t always as simple as it looks. The difference in costs is exemplified by the following three alternatives for a $5,000 loan with a $600 yearly cost to borrow.

Payment of Interest at the End of the Period The household obtains use of the money for the entire period, in this case for an entire year. The interest rate paid is given by the formula

Interest rate = Interest paid

Cash made available

= $600


= 12%

156 Part Two Ongoing Household Planning

Payment of Interest at the Beginning of the Period When interest is deducted at the beginning of the period, the amount paid in interest is the same, but the cash made available is reduced.

Interest rate = Interest paid

Cash made available

= $600

$5,000 − $600

= $600


= 13.6%

Payment of Installment Loan Under an installment loan, repayments may be made in equal sums throughout the year. The key point is that the cash made available decreases constantly through the period of the loan. Assuming a one-year loan retired in 12 equal monthly installments of interest and principal of $466.67, the cash available would decline by that amount per month.

Monthly Installment = $5000 + $600


= $466.67

The interest cost can be approximated by estimating the average amount of cash available, taking the amount at the beginning and the end of the period and dividing by 2 where:

Interest rate = Ip

1CABP − CAEP2/2 IP = Interest paid

CABP = Cash available at the beginning of the period

CAEP = Cash available at the end of the period

The reason for borrowing money counts. The approach presented here treats equally capital expenditures that generate higher cash flows and capital expenditures on leisure activities that may result only in increased pleasure. However, debt borrowed for items that increase household cash flows may be less risky. These cash flows provide resources to support future household operations. An example of a potentially attractive capital expenditure would be borrowing for education designed to materially increase a household’s future job related income. Another would be investing in a home. Borrowing to finance purchases

of durable goods would be less attractive unless it led to significantly higher cash flows. When expectations of materially higher future income are not realistic, substantial borrowing over a period of time to maintain or increase the house- hold’s current lifestyle is generally not considered desirable. This type of borrowing reduces household resources available to support its future lifestyle. Therefore, unless the borrowing is being used to smooth out yearly payments, an ongoing pattern of borrowing for such things as a vacation or fashion- able clothing may best be put off until it can be financed internally.

Practical Comment Importance of the Reason for Borrowing

Chapter Seven Debt 157

= 600

15,000 − 02/2

= 600


= 24%

The actual cost can be calculated in the following manner:

Inputs: 12 –466.675,000

Solution: 1.7882


Press i = 1.7882% (Monthly interest)

Annual interest = 1.7882 × 12 months = 21.5%

The actual annual rate is 21.5%.

Annual Percentage Rate The annual percentage rate (APR) must be given to borrowers under a federal law that requires lenders to provide an effective interest rate on consumer loans2 and the total amount of finance charges. The APR includes all defined costs such as closing fees, points, and appraisal fees on mortgage loans on a time-weighted basis. It serves as a useful method for comparing costs on loan alternatives.


In recent decades, the use of debit cards has exceeded that of credit cards. Home equity loans and lines of credit soared in popularity until the housing market crashed, resulting in the tightening of credit. As these fluctuations indicate, many issues are involved in borrow- ing money. We consider several of them next.

Sources of Debt Many financing sources are available to consumers. They differ by such factors as the interest rate charged, whether the interest cost is tax deductible, whether the loan is secured by specific assets, and whether it is a closed-end or open-end credit loan. Closed-end retail credit is generally limited to a specific loan with a specific repayment schedule. One example is an auto loan. Open-end credit provides a loan limit that can be utilized for multiple purchases over a period of time. Part payments on scheduled retirements of debt owed may be allowed. An example of an open-end loan is a credit card loan.

Interest Rates Charged by Lenders In theory, lenders should present an array of interest rates with the rate offered appro- priate to the risk of nonpayment that the individual household presents. Instead there

Calculator Solution

2 Exceptions include margin loans on securities, loans of more than $25,000 not collateralized by real property, and loans from sellers’ as former occupants of house.

158 Part Two Ongoing Household Planning

often appears to be one interest rate offered per lender. Loan applicants are placed into two risk classes,3 with one rejected and the other accepted. The lender may be basing the interest rate on the average quality of the loans, with lenders who have lower- quality borrower pools charging higher interest rates. There is some indication that for certain types of loans, the interest rate charged may not be highly sensitive to changes in market rates.4

Types of Borrowers The balance sheets, cash flow statements, and preferences for spending today differ for borrowers. The variation can be thought of as indicating two types of borrowers: unra- tioned and rationed.5 Unrationed borrowers have sufficient internal cash flow and assets to be able to select the loan maturity offering the most attractive rates. When rates change, their decisions on amount, type, and repayment period for credit may change. Rationed borrowers, on the other hand, are short of internal cash flow and would like to borrow more credit at comparable interest rates than is available.6 These borrowers, who are constantly seeking more funds, may have to take any payment terms offered.

Credit Standards A number of items are used to assess whether credit should be extended to a household; these include the amount of income earned, the amount of debt outstanding, the history of timely repayments of debt owed, and whether the loan is secured by an asset such as the durable good being purchased. Often, lenders rely upon a numerical credit score to deter- mine whether a borrower is creditworthy.7 We will return to this subject later in the chapter when we discuss credit reports and credit scores.

Outcome The outcome is that households often have a variety of borrowing alternatives at vari- ous interest rates. The ultimate selection is generally to take the lowest-cost alternative.

3 The approach may be a practical embodiment of Modigliani and Miller’s risk classes. See Franco Modigliani and Merton H. Miller, “The Cost of Capital, Corporation Finance and the Theory of Investment,” American Economic Review 48, no. 3 (June 1958): 261–297. See also Liran Einav, Mark Jenkins, and Jonathan Levin, “The Impact of Credit Scoring on Consumer Lending,” 2011, finance. wharton.upenn.edu/~mjenk/Credit_Scoring.pdf,” for a look at the impact of credit scores on the lending process. 4 D. Brito and P. Hartley, “Consumer Rationality and Credit Cards,” Journal of Political Economy 103, no. 2 (April 1995): 400–433. For a discussion on how mortgage rates relate to bond rates, see Christopher Mayer (Columbia Business School and National Bureau of Economic Research) and R. Glenn Hubbard (Columbia Business School and NBER), “House Prices, Interest Rates, and the Mortgage Market Meltdown,” 2009, law.yale.edu/documents/pdf/cbl/Mayer_Hubbard_House_Prices.pdf 5 Thomas Juster, “Consumer Sensitivity to the Price of Credit,” Journal of Finance 19, no. 2 (1964): 222–233. 6 For an explanation, see David Cox, and Tullio Jappelli, “The Effect of Borrowing Constraints on Consumer Liabilities,” Journal of Money, Credit and Banking 25, no. 2 (May 1993): 197–213, Eun Young Chah, Valerie Ramey, and Ross Starr, “Liquidity Constraints and Intertemporal Consumer Optimization: Theory and Evidence from Durable Goods,” Journal of Money, Credit and Banking 27, no. 1 (February 1995): 272–287, and Orazio P. Attanasio (UCL, IFS and NBER), Pinelopi K. Goldberg (Yale University and NBER), and Ekaterini Kyriazidou (UCLA), Credit Constraints in the Market for Consumer Durables: Evidence from Micro Data on Car Loans, Yale University, 2007, econ.yale. edu/~pg87/creditc.pdf 7 See “Key Dimensions and Processes in the U.S. Credit Reporting System,” Consumer Financial Protection Bureau (2012), files.consumerfinance.gov/f/201212_cfpb_credit-reporting-white-paper. pdf; Jane Bryant Quinn, Making the Most of Your Money (New York: Simon and Schuster, 2009): 219–221.

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This approach is consistent with centralized decision making; the decision is not neces- sarily made to link the borrowing to the item purchased but is usually made on an over- all basis. For example, instead of taking an auto loan, a household could take a home equity loan to finance the purchase of a car. As the amount of debt increases, the household will qualify for fewer loan alternatives, and the cost of credit will increase. At some point, the cost of credit discourages further borrowing or, in some cases, it can reach a government- imposed limit. Auto loans, for instance, can’t exceed the state usury rate, which might be in the 12 to 22 percent range, depending on the state.

Long-Term versus Short-Term Debt Long-term debt involves financial obligations whose terms call for final payment to be made many years from now. Although for accounting purposes it is any debt not due in the current year, it can be thought of as debt payable in four years or longer.8 Examples are home mortgages, bank debt, and other loans such as those from friends and family members. Short-term debt is money owed that is payable in a relatively brief period. For accounting purposes it is debt due within the current year whereas in investment usage, it is debt payable within three years. Examples of short-term debt are general credit card debt and credit extended by particular stores for purchases of clothing or durable goods such as a television. The length of the financing period should be matched to the size and benefits of the item creating the need for the borrowing. A house that serves as an investment will not normally be financed over a few years whereas the purchase of clothing or short-lived household goods should not result in long-term debt. In fact, many would say that the use of credit for items other than capital expenditures should be limited to repayment within 30 days or for cyclical peaks in outlays to be paid off when demand for funds lessens, generally within the year.

Secured versus Unsecured Debt Secured debt is debt that has a specific asset serving as collateral to be sold by the credi- tor for repayment in the event the debtor is unable to do so. Examples of secured debt are a mortgage and an auto loan, which are secured by the house or the automobile for which credit is extended. If someone cosigns for a loan, the loan can be thought of as secured because it obligates the cosigner to pay if the debtor does not. Unsecured debt is debt whose repayment is based solely on the full faith and credit of the debtor. Of course, in the event of default the creditor can sue to recover the money owed. Naturally, most creditors prefer secured debt because it lowers their credit risk, and they typically offer a lower interest rate for this type of loan. The disadvantage of a secured loan to the borrower is the higher probability that the asset will be repossessed in the event of financial difficulty. There are many types of borrowings. We will discuss each of the major types, starting with real estate mortgages.


Mortgages are loans secured by real property. The U.S. government has placed a priority on housing availability and affordability for the average American. The government allows interest on debt used to purchase real estate to be deductible for income tax purposes. Tax

8 In investment usage a third category, intermediate-term debt, is employed; it extends from 3 to 10 years. Debt due beyond ten years is called long-term debt.

160 Part Two Ongoing Household Planning

deductions are allowable for up to $1 million of debt for the purchase of homes and up to another $100,000 in home-backed loans for any other purpose. Because these loans have tax-deductible interest and are secured by real estate, they are often the least expensive form of borrowing available to the average household. Two government-sponsored enterprises—the Federal National Mortgage Association (FNMA), known as Fannie Mae, and the Federal Home Loan Mortgage Corporation (FHLMC), called Freddie Mac—were created to purchase mortgages from lenders such as banks or to guarantee such mortgages. During the mortgage meltdown of 2008, the U.S. government provided financing to these two companies. Consequently, Fannie Mae and Freddie Mac remained publicly traded companies but became controlled by the federal government. In return for the financial help during the crisis, Fannie Mae and Freddie Mac pay billions of dollars in dividends to the federal government each year. These two companies bundle mortgages into bondlike securities that can be sold, primarily to institutional inves- tors. The role of Fannie and Freddie in mortgage securitization supports lenders’ efforts to make fixed-rate mortgage loans to home buyers. Another entity, the Government National Mortgage Association (GNMA), known as Ginnie Mae, provides the full faith and credit of the U.S. government as a guarantee of payment for buyers of bonds secured by real estate loans, called mortgage-backed securities. The Federal Housing Authority (FHA) and the Veterans Administration (VA) insure selected mortgages against default. The net effect of these government- supported organizations is to broaden credit and offer it at a lower rate than might otherwise prevail. Obtaining a mortgage allows people to purchase a property well before they would be able to do so through cash resources alone. Applicants go through the following process in obtaining a loan.

Loan Process The Loan Application People seeking a loan fill out an application that includes such factors as current job, current income, bank accounts, and assets owned.

Assessment of the Borrower The characteristics and past history of a person as a proposed borrower are appraised. Factors include household income in relation to size of loans; household assets, particu- larly marketable ones; other debt outstanding; and credit history. Whenever possible, it is a good idea for people to clear up any blemishes on their credit records well before apply- ing for a loan. (See page 185 for a discussion of credit scores, which lenders generally use to assess borrowers.)

Home Appraisal Each house is generally given an appraised valuation based on its current market value.

Example 7.3 Craig and Dee Brown, the buyers, have offered to purchase Phil and Robin Smith’s house for $300,000. The Browns have $60,000 for a 20 percent down payment, and they apply to Jones National Bank for a $240,000 mortgage loan, which will be secured by the home. The bank will not want to extend a $240,000 loan that’s secured by a property without knowing its market value. so the bank selects an experienced appraiser to estimate it. (The buyer typically pays the appraisal fee.)

Chapter Seven Debt 161

The amount of the loan is compared with the assessed valuation; lenders often provide a maximum of 80 percent of the home’s value. If the appraiser finds the home is worth, say, $300,000, the bank can make a $240,000 mortgage loan with an 80 percent “loan-to-value” ratio. This may be considered a safe loan, so the Brown’s loan application will be accepted. If the appraised value is, say, $275,000, the bank may offer a $220,000 mortgage loan to maintain its estimated 80 percent loan-to-value ratio. Then the Browns would need an $80,000 down payment to buy the home for $300,000. Some lenders make mortgage loans for 85 percent or 90 percent of the purchase price, and the buyer will be able to make a smaller down payment. When the down payment is lower than 20 percent, the borrower may have to purchase insurance against default and/or pay a higher interest rate on the mortgage loan.

Commitment The lender finishes its credit screen and agrees to supply the agreed-upon sum to the bor- rower. Generally, the interest rate on the loan is not set until closing unless the borrower paid an additional sum to lock it in at an earlier time.

Other Other factors and other people have a role in the real estate purchase and finance process. The buyer will inspect the home, probably with an expert, to identify potential problems such as structural ones. A title search and title insurance must be implemented and prop- erty insurance purchased. The realtor, if any, who helped find and negotiate the price will be getting a commission. Attorneys coordinate the process in many respects; often each party—buyer, seller, and lender—has a separate attorney.

Closing All parties to the purchase of the house meet, and all terms, including the interest rate, which is based on market factors at the time, are set according to the contract. The contract is signed, and title is passed to the buyer. Points are fees paid at the closing to the bank to cover their administration fees. Each point is 1 percent of the sale price: It would be $3,000 on a home sale whose contract price is $300,000, for example. Borrowers are often allowed to reduce the interest cost on the loan by selecting the number of points they will pay at the time of closing. The more points, the lower the inter- est rate will be; sometimes there will be a one-quarter-point decrease in the loan’s interest rate for each point paid at the time of closing. The points can be tax deductible in the year the house is purchased as the buyers’ first-time financing of a home. Otherwise, points are deductible in equal amounts over the life of the mortgage. The vast majority of mortgage loans are amortizing loans, as is true of most long-term consumer debt. This means that both interest and principal are paid off over time. At the beginning of the term of the loan, the largest part of the payment is interest, but as prin- cipal is paid off and interest cost is reduced, a rising portion is applied to the pay down of principal. Toward the end of the mortgage, the overwhelming amount is usually applied to repayment of principal. The most common period for mortgages is 15 or 30 years. The breakdown of total cash outflow into payments of principal and interest is shown in Table 7.1. The impact of mortgage payments on most households’ cash flow tends to lessen over time. Incomes tend to rise, but mortgage costs often are fully or approximately level. Therefore, the household mortgage burden usually declines over extended periods. Moreover, as the portion of the monthly payment that is principal increases, the net equity in the house rises more quickly. Example 7.4 shows how to calculate monthly mortgage payments.

162 Part Two Ongoing Household Planning

Inputs: 360 0.6 200,000

Solution: –1357.58


Press PMT = ($1357.58)

Prepayments on Mortgage Debt Any household generating the necessary cash flow can consider prepayments of mortgage debt. For example, some households think about paying their mortgage every four weeks instead of monthly, which in effect results in one extra payment a year. Their goal is, of course, to eliminate their debt earlier. The prepayment decision for mortgage or any other debt should be looked at as an alter- native investment decision. The after-tax interest cost on the debt retired should be compared with the after-tax return on investment alternatives. For a fair comparison,

Calculator Solution

Mortgage amount $200,000 Annual interest rate 7% Monthly interest rate 0.5833% Loan term (in years) 15 Loan term (in months) 180 Monthly payment $1,797.66 Annual payment $21,571.88

Year Total Payment at End of Year* Principal Interest

1 $21,571.88 $7,819.60 $13,752.28 2 $21,571.88 $8,384.88 $13,187.00 3 $21,571.88 $8,991.02 $12,580.86 4 $21,571.88 $9,640.98 $11,930.90 5 $21,571.88 $10,337.93 $11,233.95 6 $21,571.88 $11,085.26 $10,486.62 7 $21,571.88 $11,886.61 $9,685.27 8 $21,571.88 $12,745.89 $8,825.98 9 $21,571.88 $13,667.30 $7,904.58 10 $21,571.88 $14,655.31 $6,916.57 11 $21,571.88 $15,714.74 $5,857.14 12 $21,571.88 $16,850.76 $4,721.12 13 $21,571.88 $18,068.90 $3,502.98 14 $21,571.88 $19,375.10 $2,196.77 15 $21,571.88 $20,775.73 $796.15

*Mortgage payments for a $200,000 loan at a 7 percent interest rate for 15 years (using payment schedule).

TABLE 7.1 15-Year Mortgage Payment Model

Example 7.4 Max just closed on a house and has taken out a 30-year fixed-rate mortgage for $200,000 at a 7.2 percent rate. What is the monthly mortgage payment?

Change annual rates into monthly figures.

Amount Explanation

Monthly interest rate 0.6% 7.2%

12 months Number of compounding periods 360 30 years × 12 months

Chapter Seven Debt 163

prepayment and the investment alternative should have approximately the same risk, or the returns should be adjusted for difference in risk. One other factor to consider is liquidity risk. Paying off debt can reduce the amount of money available in the event of an unforeseen need for cash. An investment in marketable securities can be liquidated within a few days if circumstances make borrowing money difficult—for example, the loss of a job.

Example 7.5 Alex was a conservative investor with a considerable amount of available cash. He invested all of his money in taxable bonds, which at the time were yielding 4 percent annually. He had a mortgage with a 6.5 percent interest rate. He was considering investing his current year’s savings in the bonds. Then he realized that prepayment of his mortgage could be considered as an alternative investment vehicle. Alex thought about the tax savings he would lose on the tax-deductible interest expense if he prepaid. On the other hand, investing in the bonds instead would subject him to taxation on the interest income received. What it came down to was whether the interest saved on the mortgage exceeded the rate of return on investing in the marketplace with securities of approximately the same risk. He already had plenty of cash for emergencies. Assume that Alex’s marginal income tax rate is 30 percent, and that he itemizes deductions on his tax return. Receiving 4 percent on taxable bonds earns 2.8 percent (70 percent of 4 percent), after tax. Paying down a 6.5 percent mortgage is equivalent to earning 6.5 percent, before tax, or 4.55 percent (70 percent of 6.5 percent), after a tax deduction in a 30 percent tax bracket. Thus, the 6.5 percent expense saving from the mortgage prepayment substantially exceeded the 4 percent hurdle rate, and he began prepaying the mortgage.

Types of Mortgages Basically, there are two types of mortgages: fixed and variable (adjustable-rate) mortgages. Each has distinct advantages and disadvantages.

Fixed-Rate Mortgages The interest rate remains stable over time with fixed-rate mortgages (FRMs). They offer the certainty of a level rate of interest over the life of the mortgage. Because interest rates don’t fluctuate, there is no interest rate risk9 for the borrower. Many homeowners are attracted to fixed-rate mortgages, which have two benefits. They lock in a rate of interest that will be unaffected by a rise in market rates. They also provide the opportunity to refinance (replace the existing mortgage with a new loan) should market rates decline. On the other hand, homeowners pay a price for these benefits because the interest rate will generally be higher than the rate on an adjustable mortgage.

Adjustable-Rate Mortgages Adjustable-rate mortgages (ARMs) are those whose interest rates to the borrower fluc- tuate yearly based on overall market rates of interest at the time. They are based on a benchmark rate of interest, such as the rates on one- or three-year U.S. Treasury obligations or the Federal Home Loan Bond Rate, which tends to be less volatile. The mortgage rate is equal to the benchmark rate plus an additional amount, often 1 to 3 percent. Adjustable-rate mortgages often have lower rates of interest than fixed-rate mortgages over the term of the loan. To compensate for assuming the risk of fluctuations in interest rates, the borrower receives a lower rate. The most pronounced difference in rates occurs within the first three years, when borrowers are frequently offered below-market interest rates as an induce- ment to get them to take an adjustable-rate loan. The lower initial rate makes it easier for homeowners to qualify to purchase a larger house or larger loan. This is true because lenders tend to look at total interest costs in relation to household income in the first year of the loan.

9 Except for the cost of refinancing.

164 Part Two Ongoing Household Planning

The materially lower interest cost in early years can prove attractive for homeowners who expect to move within a few years. They have the comfort of knowing that should interest rates decline, their cost will be adjusted down without the need to refinance. Fixed- rate loans often require significant costs to refinance. On the other hand, adjustable-rate mortgages are disadvantageous when rates rise. They don’t allow homeowners to lock into a rate, although it is possible to switch to a fixed-rate loan when interest rates are low. With an ARM, it is impossible to calculate the true cost of the loan because homeown- ers don’t know how long they’ll own the home or how interest rates will move over time. An extended stay during a period of sharply rising interest rates can make an ARM a very expensive loan. Many adjustable-rate loans provide interest rate limits called caps. The caps limit the increase for any one-year period and provide for a maximum rate that can be charged over the life of the loan. If rates rise sharply, borrowers of ARMs can be subject to negative amortization, which means that the monthly payment does not cover the higher interest cost. Consequently, the amount of the mortgage outstanding increases rather than declines. In response to borrower concerns about interest rate fluctuations, many lenders offer what can be termed a hybrid ARM. This is a mortgage that offers a fixed rate for a fixed period of years and then reverts to an adjustable rate. The so-called 5/1 ARM has become the most popu- lar type in many markets. It is a fixed loan interest rate for five years, after which there will be an annual adjustment to market rates. Clearly, such a mortgage is actually a fixed-rate loan for a buyer who expects to move within five years, perhaps after starting or expanding a family. Table 7.2 summarizes the advantages and disadvantages of the two types of mortgages.

Fixed Rates Variable Rates

Interest rate risk Lender assumes the risk of increase in rates

Borrower assumes risk of increase in rates

Rates decline Borrower can refinance when interest savings exceed fixed cost of refinancing

Rate changed automatically and declines on yearly benchmark date

Relative interest cost Higher due to flat-rate guarantee and refinancing option

Lower due to borrower absorption of interest rate risk

Projected holding period

No material advantage or disadvantage Can have advantages in cost if only holding for a few years due to benefits of teaser rate

Qualification for loan More difficult than for ARM Easier due to low initial teaser rate

TABLE 7.2 Summary of Mortgage Characteristics

People sometimes place too much emphasis on the initial rate on ARMs, which can appear highly attrac- tive. In fact, their rates are known as teaser rates. What can be more important is the length of time the rate will be in effect and, even more signifi- cantly, the interest rate when the teaser rate expires. The full rate, the one that is in effect after the teaser rate expires, is based on the current bench- mark rate plus an add-on rate and is often the more meaningful one for decision purposes. For example,

two mortgages may be similar in all respects except that one offers a 5 percent teaser rate for one year and then an adjustable rate benchmarked to the one-year U.S. Treasury bill plus 2.75 percent. The other has a 6 percent teaser but is then bench- marked to the one-year Treasury plus 1.50 percent. It is simple to conclude that the second, which saves 1.25 percent each year over the rest of the loan period, is more attractive.

Practical Comment Analyzing the Adjustable Rate Mortgage (ARM)

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Refinancing Refinancing is an alternative when market rates decline. It is most often exercised by hold- ers of fixed-rate loans. Holders of ARMs also may switch to a fixed-rate loan if they per- ceive the current fixed rate to be attractive. This would happen when rates are expected to rise. To determine whether it is profitable to refinance, the savings in interest cost over the term of the loan held is compared against the current outlay for refinancing. Refinancing costs including points, lawyer fees, title insurances, and so on are significant. Thus, whether to refinance becomes a capital budgeting decision. In calculating the cumulative savings from refinancing, mortgage holders should incorporate the possibility of selling the home and repaying the mortgage prior to the end of the mortgage period. The National Association of Home Builders has reported that the average length of stay in a single-family home is a 13 years for all home buyers.10 As mentioned, home mortgages are often for 15 or 30 years. In the years after the housing market collapse of 2007–2008, steep declines in fixed-rate mortgage interest rates made mortgage refinancing more frequent.

Example 7.6 Elena has 15 years left on her 30-year fixed-rate mortgage, which has an 8 percent interest rate. She is thinking of refinancing because mortgage rates have declined to 7 percent. She has $140,000 left on her mortgage and would have to pay $3,000 to refinance. Assume that it is all tax deductible. Elena expects to live in the house for another seven years. She is in the 28 percent marginal tax bracket and can earn 6 percent after tax on an alternative use for the money. Should she refinance?11

10 Paul Emrath, “How Long Buyers Remain in Their Homes,” Special Studies, 2013, HousingEconomics. com, http://www.nahb.org/generic.aspx?sectionID=734&genericContentID=194717&channelID=311 11 Calculation is approximate because, among other things, the savings in interest expense will decline as the mortgage does. 12 For an explanation of the internal rate of return (IRR) evaluation of rates of return generated by it, see Chapter 8.

Calculator Solution12

General Calculator Approach HP12C TI BA II Plus

Clear the register f FIN

CF 2nd CLR Work

Enter initial cash outflow 3,000 CHS g CFo 3,000 +/− ENTER ↓ Enter yearly savings 1,064 g CFj 1,064 ENTER ↓ Enter number of years 7 g Nj 7 ENTER ↓ Calculate the internal rate of return f IRR




Amount Explanation

Cost to refinance $3,000 As given Yearly tax-deductible amount $200 3,000 ÷ 15 years Yearly tax savings $56 200 × 0.28 Yearly savings from rate decline 1% 8% − 7% Yearly interest savings pretax $1,400 140,000 × 1% Yearly interest savings after tax $1,008 1,400 × (1 − 0.28)


Yearly tax savings $56 Yearly interest savings after tax $1,008 Total yearly savings $1,064

166 Part Two Ongoing Household Planning

The 30 percent rate of return is attractive relative to the 6 percent investment alternative. Therefore, the mortgage should be refinanced. The loan value and interest rate savings will de- cline over the term of the loan. Consequently, this yearly savings is somewhat overstated. For a more accurate figure, use the breakdown of interest cost on the mortgage repayment schedule.

Home Equity Loans A home equity loan is one that is secured by the homeowner’s house. In effect, it is a second mortgage, which means that it has a second priority on the house. In the event of nonpayment, the lender will not be repaid from the proceeds from the sale of the property until after the first mortgage holder is paid off. Because of this higher risk, the interest rate charged will be higher than that on a first mortgage. On the other hand, a home equity loan is secured by a substantial asset, and homeowners are generally reluctant to default on the house they live in. Therefore, the pretax cost of a home equity loan is still among the lowest available to the consumer. Moreover, the outlay for interest on the first $100,000 of borrowing on a home equity loan for single or married persons (or $50,000 if married and filing sepa- rately) is tax deductible regardless of the purpose of the loan. Those tax-deductible interest payments are in addition to the deduction for interest payments on up to $1 million of home acquisition debt, which refers to mortgages used to buy, build, or improve the own- er’s home or homes.

Example 7.7 Emily Foster has a $500,000 mortgage on her primary residence, a $80,000 mortgage on her vacation home, and a $75,000 balance on her home equity loan. All of the interest she pays is tax-deductible. However, if Emily had taken out a $115,000 loan, only the interest on the first $100,000 of the loan would be deductible. It does not matter whether Emily uses that $40,000 to buy a car or to add a swimming pool to her home, she would not receive a tax deduction on the last $15,000.

When substantial loan amounts are needed for work on the house or for other purposes, the homeowner may have the choice of taking out a home equity loan or refinancing the first mortgage for a larger amount. The two relevant factors in making such a decision are the interest rate on the mortgage outstanding and the amount by which the interest rate on the proposed home equity loan exceeds the current market rate on a new first mortgage. It is often best to take out a home equity loan when the rate on the homeowner’s exist- ing first mortgage is well below the market rate and the total sum of the original mortgage is large relative to the total amount of housing debt that will be outstanding after the addi- tional borrowing. Frequently, it is better for homeowners to refinance when current rates are lower than those existing on the first mortgage. Although home equity loans may contain front-end closing costs, competition has sometimes compelled lenders to waive them.

Example 7.8 Martin and Kristin both had need for an additional $4,000 in cash and had to decide whether to refinance their existing mortgage to obtain a larger sum or to take out a home equity loan instead. The market rate on a new mortgage loan is 6 percent whereas the one on a home equity loan is 7.5 percent. Martin has a 7 percent existing fixed-rate mortgage with $100,000 left on it, and Kristin has a 10 percent fixed-rate mortgage with $210,000 remaining to pay. Martin is probably better off with a home equity loan because of the low rate on his existing mortgage and the thousands of dollars in closing costs he’d have to pay to obtain a new first mortgage. Kristin, on the other hand, is better off refinancing rather than taking the home equity loan. She will save money on the new mortgage over the existing one. She would save four percentage points by refinancing a much larger sum than Martin’s. The ability to save so much on her entire borrowings makes it the best choice for her.

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Because a home equity loan is often the only loan that qualifies for a tax deduction, it is often the lowest-cost loan for those who qualify and can be particularly useful in financing sizeable purchases of any type such as those for automobiles.

Home Equity Line of Credit Closely aligned with a home equity loan is a home equity line of credit (HELOC). Instead of providing a fixed sum as a home equity loan does, a HELOC allows borrowers to draw down part or all of a maximum amount as they wish. As with a home equity loan, a HELOC represents a second mortgage on the property. The advantages of a HELOC are the flexibility to take out only what is needed and the ability to pay just interest, not prin- cipal, for an extended period of time. The disadvantages of a HELOC range from a potentially higher level of interest and greater vulnerability to a boost in market interest rates because there may not be an interest rate cap as there is with an adjustable-rate mortgage (ARM). In addition, the lender is given the right to withdraw the line of credit periodically, which, if it did, would necessi- tate either refinancing elsewhere or otherwise finding the funds, or risk losing the home. Indeed, many HELOCs were frozen, reduced, or withdrawn altogether in the years imme- diately after the real estate bubble burst. A HELOC can be viewed as resembling a credit card that is secured by a home. Generally, HELOCs and home equity loans have comparable interest rates;13 both types offer a considerably lower after-tax cost when compared with a credit card loan.

Historically, home ownership has been one of the linchpins of a secure retirement. Often when people have reached their early 60s, the mortgage has been paid off, which reduces the cost of living in retire- ment. Moreover, if people sell their house to move to a smaller residence, or to a less expensive location, they frequently generate free cash. By offering home equity loans, often without extensive paperwork, time, or cost, banks have made it convenient to use the house as a source of low-cost credit. Retirees with no paychecks coming in, may have difficulty qualifying. Therefore, preretirees may want to ac- quire a home equity line of credit (HELOC) while they are still working and have enough income to qualify for the loan. Subsequently, the HELOC probably will remain in place after retirement. The credit terms for a home equity loan or a HELOC may be largely the same for a younger bor- rower whose income will rise and who will have many years to repay and for an older person with fewer years until retirement. The borrowing limits on home equity debt are higher than those on a credit card because the lender has a secured asset.

Although a homeowner could always have refi- nanced a first mortgage or taken out a second one, the up-front processing cost and time to close made it attractive only for major additional borrowings. The home equity loan, on the other hand, can be used in ways that differ little from that of a major credit card. The result can be a slowly mounting accumulation of debt over time that reduces the equity in a home by the time the owner retires. Therefore, the home equity loan in practice has advantages and disadvantages. It is usually the low- est-cost source of debt except for a first mortgage, with fairly easy access to it. At the same time, a home equity loan reduces the benefit of the forced savings component of the house through pay down of debt over time. Consequently, for homeowners with weaker discipline and less foresight, the monthly repayment has the potential to erode their standard of living in retirement. Retirees who are unable to raise cash through an acceptable home sale or receive home equity loans may consider a reverse mortgage for needed credit. (See page 401 for details on reverse mortgages.)

Practical Comment Home Equity Loans and Retirement

13 The APR for a HELOC cannot be compared with the one for a home equity loan because the components entering the calculations for the two differ.

168 Part Two Ongoing Household Planning


Credit card debt is the most common form of consumer loan debt in the United States. Credit cards can be distinguished from debit cards. Unlike credit cards, debit cards are not a source of additional funds through borrowing cash because the amount paid for pur- chases with a debit card are automatically deducted from bank balances. Credit card debt typically comes from purchasing consumer goods, although withdraw- als for cash are permitted. If repayments are made within a grace period (which must be at least 21 days, under the Federal Credit Card Accountability, Responsibility and Disclosure Act of 2009), no interest is charged. Thereafter, monthly interest is charged using various methods that may be based on the previous month’s closing balance or those sums outstanding, which more accurately reflect payments during the month. Interest on credit cards is often offered at a high rate relative to interest on other con- sumer loans. Selected individuals with strong assets and credit histories may receive below-average credit card rates, but these still may be above that for many other consumer loans. Many advisors, including financial planners and accountants, view credit cards as an “evil lure,” tempting people to spend more than they should and then charging them double-digit rates that can make repaying the loan difficult. The public, on the other hand, uses them heavily. It can be instructive to identify the reasons why they are so popular. First, credit cards can be utilized as a convenience card. As long as the money is paid off during the month, there is no interest cost; in effect, the holder receives free credit. Convenience for some also means using a card instead of carrying large amounts of cash and having to count out payments needed and receiving smaller cash sums as change. Second, credit cards have the advantage of helping people structure their lives. Credit cards can be used to even out flows of expenditures without disrupting normal income and savings patterns. For example, normal monthly savings can continue while the increase during the summer for vacation expenses can be financed by credit cards and repaid over the next several months. Third, credit cards can be employed as an alternative to holding larger cash balances. Large cash balances are used as a precaution against running out of liquidity in the event of unforeseen circumstances. Although the cost of credit card debt may be higher than that for investment alternatives, the debt is used for only part of the year for emergencies or for cyclical spending and is repaid promptly. Thus, the debt can be repaid when cash flow permits14 making the use of credit cards an efficient way to borrow. In this way, the ability

For some people, an aspect of credit card spending may not be entirely rational. The ease with which people can purchase on credit can lead to impulsive spending on nonessentials. Moreover, some credit card users appear to have no sense of the current loss that could come when taking money from a wallet or purse. Others believe that they will pay off the debt before interest charges take effect despite the fact that similar past belief has led to higher debt, not re- payments. For people who use credit cards excessively,

the use of increasingly popular debit cards may be a better choice. Another solution, consolidating credit card loans into a much lower-costing home equity loan, is normally a great idea but may be counterpro- ductive for undisciplined spenders. Too often such consolidation subsequently leads to additional debt through new credit card payments. Those undisci- plined spenders should just remain with their credit card debt maxed out as a spending discipline imposed by outside financial firms.

Professional Advice Credit Card Behavior and Consolidating Loans

14 When not repaid according to the repayment schedule, a person’s credit rating could be impaired.

Chapter Seven Debt 169

to use credit cards can permit existing cash funds to be used for a full year at normal in- vestment returns instead of at lower precautionary money market returns. Finally, when credit card debt is compared with regular bank loans, the bank loans are more costly for amounts under a few thousand dollars when fixed costs and transaction costs are included. For larger amounts, credit card debt in some cases may still be attrac- tive versus full-period loans if it is outstanding for only part-period peaks in expenditures. In sum, credit cards do have significant advantages that can help account for their popu- larity. However, as the following Practical Comment indicates, these cards must used with the personalities and behavior patterns of the people in mind.


Margin debt is money generally offered by securities dealers to help finance the purchase of marketable investments such as individual stocks, bonds, and mutual funds. The securities serve as collateral for the loan. The Federal Reserve sets the maximum amount available for borrow- ing. It is 50 percent of the fair market value of the securities on margin upon original purchase.

Example 7.9 Greg wants to buy $1,000 worth of stock on margin, and so he must commit at least $500 in cash or other collateral, which would mean taking a $500 margin loan. Going forward, broker- age firms and investment exchanges impose ongoing maintenance margin requirements, which generally have a 25 percent minimum. That $1,000 of stock might fall to $667, reducing Greg’s stake to $167, the current value minus his $500 margin loan. With $167 in equity on $667 of stock, Greg’s net value in this position is roughly 25 percent. Any further drop in the stock price would generate a margin call, requiring Greg to provide additional funds to his broker.

Given the advantages stated on page 168, despite the negative opinions among the financial press and many advisors, credit cards sometimes can be an ef- ficient source of credit. Moreover, you can use credit card statements, possibly in coordination with your checkbook, as a fairly simple way to identify your total expenditures, to easily separate them by type, and to plan and execute monthly payments. In other words, credit cards have some distinct advantages in convenience of use and in structuring repayments. Whether they are used efficiently or become an on- going problem depends on the borrower’s personality. Basically, there seem to be two types of people: savers and spenders.15 Savers operate under the life cycle theory, putting away appropriate sums for retirement, unforeseen emergencies, and college expenditures for any children. They use credit cards as a rational finan- cial alternative. Spenders may emphasize pleasure today. In economic terms, they have a high marginal rate of time preference.16 Spenders may have difficulty putting away resources for the future, even when they recognize the importance of doing so. Many spenders seek help through structure, including planned-out actions. For example, they

may prefer that monies be withdrawn directly for retirement savings rather than have money pass through their hands. By contributing to employer- sponsored plans such as 401(k)s via paycheck withholding, spenders can benefit from imposed savings. Credit cards can be the antithesis of what they need. Although credit cards can structure re- payments, consumers must have the ability to make them. Otherwise, the credit card represents an ongoing opportunity to spend without immediate consequence, wherever they go. People also may deemphasize the cost of credit because there is no current impact. Some spend up to the limits that companies offer. Ironically, these credit card users may not be good candidates for a loan to consolidate their debt—for example, a home equity loan. They need the structure of being “maxed out” on their credit cards. It is because of such people that credit cards have developed negative connotations.

Practical Comment Credit Cards and Personality

15 http://www.nahb.org/generic.aspx?sectionID=734& genericContentID=194717&channelID=311 16 See Appendix I to this chapter for an explanation of the term.

170 Part Two Ongoing Household Planning

Because of the ease with which the lender can liquidate the collateral in the event of default, the margin loan rate is often among the lowest pretax rates available to the bor- rower. In addition, margin debt is tax deductible up to the amount of taxable interest and dividend income for the year. The amount of margin interest expense that is higher than this income can be carried forward to the next year for a future tax deduction.17 The deduc- tion is available only for loans made for investment purposes. Therefore, a margin loan intended to finance a noninvestment item would not qualify.


A loan that is secured by a valuable asset can have a relatively low rate. That asset can be liquidated by the lender to pay off the loan in the event of nonpayment. The most common example is an auto loan. In assessing auto loan rates, a credit subsidy by the manufacturer or dealer should be separated from interest rates for this type of loan. The interest rate can be a disguised discount on purchase of the automobile. If so, in some cases, a higher dis- count may be made available for cash purchase. When a cash purchase has no benefit for discount purposes, the subsidized interest rate can be very competitive. In the absence of a highly subsidized rate, a home equity loan that is available generally is a less expensive way to finance this large capital outlay.


Bank loans can be made for purposes other than purchase of a home. They come in many forms and are either amortized over the life of the loan or due by a specific date. Banks qualify borrowers according to the purposes of a loan, household income, assets, and credit history. Bank loans not made through credit cards can be lower than those for many other unsecured borrowings—particularly for qualifying borrowers who borrow significant sums.


Credit unions, also called credit associations, are set up by individuals or companies that lend money to their members. In some cases, the rates are highly competitive, which can be attributed to such factors as the association’s nonprofit status, the absence of marketing expenses, and, often, the above-average credit quality of its members.


A loan against 401(k) or other pension assets can be taken if the employee plan permits it. Individual companies may set guidelines, but overall limits are 50 percent of the borrow- er’s vested account balance or $50,000, whichever is less. The approach varies from assets withdrawn and interest costs paid directly to the employee’s pension to loans against assets with monies paid to the company and pension assets staying intact. The time frame for re- payments is generally stated; maximum repayment dates are set by the government, gener- ally for a maximum of five years. When repayment terms are not met, loans become distributions subject to income tax and potentially a 10 percent penalty tax. The interest cost to borrow is established by the employer and can vary from plan to plan.

17 There is also the option to use capital gains income to offset taxable interest expense but doing so will reduce the ability to use low tax rates on capital gains.

Chapter Seven Debt 171


After certain life insurance policies—for example, whole life policies—have existed for some time, they can develop significant cash values. Those amounts can be borrowed in a process that is somewhat similar to that for loans from pension plans. However, repayment terms, if any, are less stringent than those for pension plans. The rates for borrowing from cash value are stated in the contract. Sometimes taking out loans on policies can result in lower assigned rates of return on the cash value of policies. Older policies at low rates can make attractive borrowing alternatives.


Various other loans are available, including those from retail establishments to purchase their goods, from consumer finance companies to receive cash, and from pawnbrokers who require assets deposited as collateral. Their costs may be higher in part because the rate of nonrepayment of the debt may be higher than for, say, a bank loan.


College loans are often made based on need. The rates on these loans granted by the fed- eral government or a college or university to full-time students can present an attractive alternative for those who qualify. A $2,500 tax deduction is available for student loans, but it is phased out based on modified adjusted gross income (MAGI) of $65,000–$80,000 for singles and $130,000–$160,000 for those filing joint returns. Mandatory payments are set up once income-producing activities begin.


Loans from relatives and friends can be a significant source of financing. Typically, the personal relationship is a factor in extending the loan. However, the loan itself must con- tain a market-related interest rate. If it doesn’t, the loan can be considered a gift, and the borrower will not be able to deduct the interest paid.


Once the money has been borrowed, the interest expense is generally considered a nondiscre- tionary cost in the cash flow statement, regardless of the purpose of the loan. For example,

When cash loans can be taken directly from pension accounts such as 401(k)s, pension holders sometimes find these loans appealing because borrowers feel they are “paying interest to themselves” and that the transaction has a tax benefit. In reality, there may not be any extra benefit. Although the amount borrowed

is not subject to income tax as is the case with most consumer loans, the interest paid is not tax deductible. Borrowing monies that would have been invested in securities can have better or worse results, depending on the performance of the investments in the pension account during the period the money is withdrawn.

Practical Comment Evaluation of Pension Loans

172 Part Two Ongoing Household Planning

whether the borrowing occurred to purchase skis, food, a house, or common stocks, the interest expense related to these purchases becomes an ongoing nondiscretionary cost for the household. A summary of the relevant characteristics of loan alternatives is presented in Table 7.3. Pay particular attention to the cost column. Wherever possible, it will typically be most beneficial to select the lowest-cost alternative.


Contingent liabilities are potential cash outflows depending on the occurrence of a possible event. For example, a person who cosigns for a loan taken by another person will be obli- gated to pay if the other person defaults. Two examples of contingent liabilities follow. If homeowners don’t eliminate the ice on the sidewalk in front of their homes, they may be vulnerable to a lawsuit if someone slips and is injured. Architects are fully aware of their vulnerability should faulty building design result in injury to people. When the likelihood of payment is high or the exposure very large and not covered by insurance or other prac- tices, the amounts should be incorporated in debt considerations. In the next part of the chapter, we will discuss important specialized topics in debt man- agement. We will begin by explaining credit reports, move to consumer laws in finance, and then consider financial difficulties and bankruptcy. Our planning efforts are intended in part to minimize those difficulties. The last section of the chapter on financial ratios provides ways to measure our current status to help reduce financial difficulties and pro- mote sound borrowing practices.

Loans from friends and family members are often fraught with risk. The problems are due primarily to different perceptions. Communication about the in- terest and repayment terms is often vague. For ex- ample, the borrower may assume that the loan will be paid off in a few years when he or she can afford to do so. However, the lender may come away with the belief that the money will be repaid much more quickly—as soon as the borrower’s liquidity problem has been resolved. Each party may have a different point of view about whether such items as vacations come before or after repayment. Each may be uncomfortable with discussing the terms in what can be a combined business and personal transaction. When it becomes apparent that the two parties understand the loan terms differently, one or both may become frus- trated, but the personal relationship may prevent them from speaking about it. The net outcome can sometimes harm that relationship. To overcome the potential problem, it may be best not to borrow from people with whom the borrower has a close relationship. When borrowing

is to take place, it should be done in a strict busi- nesslike way with the borrowing terms (including the interest rate) and repayment schedule estab- lished. An exception can be made for monies lent by parents to children, particularly for down payment on a new home. This loan has an emotional side in- cluding an attachment that extends beyond financial returns. The sum provided may not truly be a loan but can be an advance against an estate distribution with repayment required only if the parents need the money. When there is true loan intent, it too should be handled in a businesslike way. Indeed, a formal home buyer’s loan from parent to child can benefit both parties, if the parent receives a significant yield while the child pays a competitive interest rate.18

18 Teri Agins, “When a Friend Asks for Money, Try Saying ’No,’” The Wall Street Journal (Eastern edition), August 6, 1985: 1; Eric S. Toya, “Intra-family Loans Can Help Children Get a Home,” Financial Planning Association, 2011, fpanet. org/ToolsResources/TipoftheWeek/PastTips/HomeOwnership/ IntrafamilyLoansCanHelpChildrenGetaHome/

Practical Comment Loans from Friends and Relatives

Chapter Seven Debt 173


Credit reports are factual printouts that include an evaluation of a person’s creditworthi- ness. Creditworthiness is developed using a scoring system. The higher the score, the more likely the person is to receive credit and, in some cases, the lower the interest rate will be. Perhaps the most frequently used system is one developed by Fair Isaac Co. (FICO) for credit bureaus. Each major credit bureau has its own score based in part on FICO. The fac- tors considered in scoring by the companies include these:

Type of Credit

Cost of Credit (pretax)

Tax Deductible

Cost of Debt (after tax) Secured Explanation

First mortgage Closed end Very low Yes Generally the lowest

Yes Tax deduction limited to $1million per home when purchased or redeveloped, $1.2 million per two homes

Home equity: Second mortgage Line of credit

Open end Low Yes Very low Yes Maximum tax deduction limited to building cost plus $100,000 for all purposes*

Credit card debt Open end High No High No Other factors may reduce effective interest rate for noncontinuing debt

Credit association loan

Closed end Low to medium

No Low No

Bank loan Closed end Medium No Medium Varies Pension loan Closed end Low to

medium Not for interest cost

Low to medium


Insurance loan Open end Low to medium

Not for interest cost

Varies Yes

Educational loan Open end Low to medium

Yes† Low to medium


Loan from friends and relatives

Varies Varies No Varies Usually not

Other Loans: Closed end High No High Varies Finance company Pawnbroker etc.

*Actual tax deduction restricted to the interest on debt equal to the home’s fair market value minus other debt secured by the home or $100,000, whichever is smaller. † Interest on educational loans may be tax deductible up to $2,500 per year.

TABLE 7.3 Summary of Loan Alternatives

Factor Explanation

Past credit history The most heavily weighted item. To receive a high score: No amounts-past-due disputes, charge-offs, bankruptcy; it is not good enough to pay off debt; it must be repaid on time.*

Married Higher score. Two wage earners Higher score. Age Being young or old means a lower score. Children Higher score.


174 Part Two Ongoing Household Planning

Generally, the most important items in the score are the person’s past payment history, the amount of money owed, when the person last applied for credit, and how long he or she has had credit and the kind of credit. FICO scores range from 300 to 850; those below 650 may be considered weak while those above 750 are excellent. When credit scores slip, say from good to weak, borrowing rates can be altered. Good credit also can be used as a screen of job applicants and for insurance applications. As we have seen, during the real estate boom earlier in this century, credit was easier to ob- tain than it was 10 years earlier, which resulted in more delinquencies. A person who is rejected for credit must be given a reason. If there is an amount in dispute, the individual has the right to explain the reason for it in 100 words and have the statement placed in her or his credit file. There are three major credit bureaus: Equifax, Experian, and TransUnion. Each uses the FICO data to develop its scores. Because some credit providers subscribe and send credit information to only one or two bureaus, an individual can obtain a credit report from each bureau. This can mean that individuals who want to check their credit should do so with all three bureaus. The credit report provides their credit history, any inquiries about it, and any relevant public information, such as bankruptcy, for a period of time. A free credit report free,19 can be ordered online,20 by calling a toll-free number,21 or send- ing written requests.22 Under federal law, individuals are entitled to receive one free credit report from each bureau for each 12-month period. In addition, they can get one free if they are denied credit, are unemployed and looking for work, think they have or may have been the subject of a fraudulent credit transaction, are on welfare, or have been told by a company that it will be reporting something negative about them to a credit bureau. Additional requests per year are available at a cost. Under Federal Trade Commission (FTC) guidelines provided in the Fair Credit Reporting Act, individuals can obtain a copy of their actual credit score and the way it was developed from any of the credit bureaus for a “fair and reasonable” fee.23

Taking the steps indicated in Table 7.4 can improve credit scores. For an explanation of consumer protection laws including those for credit cards, see Appendix II to this chapter. Privacy and identity theft are discussed in Appendixes III and IV, respectively.

Job The more skilled the job, the more stable it is, the higher the score. Years at job The longer, the higher the score. Mix of credit types Higher score. Years at current residence The longer, the higher the score. Years at previous residence The longer, the higher the score. Current debt obligations The lower the amount, the higher the score. Favorable credit history

At bank granting loan Very favorable for score. At any bank Favorable for score.

*The longer a past due item is outstanding before being paid off, the lower the score.


Factor Explanation

19 Do not contact the three nationwide credit-reporting companies individually; instead see the information in the next four footnotes. 20 The Website for the credit report is annualcreditreport.com/. 21 The toll-free number is 1-877-322-8228. 22 The mailing address is Annual Credit Report Request Service, P.O. Box 105281, Atlanta, GA 30348-5281. 23 See “Where can I get my credit score?” Consumer Financial Protection Bureau, August 22, 2013, consumerfinance.gov/askcfpb/316/where-can-i-get-my-credit-score.html

Chapter Seven Debt 175


Financial difficulties can be defined as problems in simultaneously supporting normal household operations and paying interest and principal on debt owed when they are due. These difficulties may be attributable to lower-than-expected earnings or layoffs, unantici- pated costs, improper planning, investment setbacks, or simply unwise spending. When a cash flow problem is just temporary, a partial liquidation of investments or a consolidating loan may be enough to solve the problem. Under a consolidating loan, the proceeds from one lender are used to repay many loans, such as debt outstanding from a variety of credit card sources. The terms of payment may be extended in time to allow better matching of cash flow availability in relation to interest and principal costs. In some cases, the total interest expense may be lower as well. When the problem is more fundamental, either an additional revenues from sources such as a new or extra job must be found or a cutback in overall expenses must be imple- mented. The cutback can take place in selected significant costs such as entertainment, vacationing, eating out, or, more extremely, housing. Alternatively, an across-the-board percentage reduction in costs can be effected. Typically, an operating budget should be monitored to ensure that it is adhered to. Often it is helpful to restrict the use of credit cards. If the problems are more pronounced, personal bankruptcy may be considered.


Bankruptcy is a way for people to lessen or eliminate the burdens of debt. It is executed under court proceedings and therefore has legal standing that protects the filer from creditor claims. The number of bankruptcy filings has increased in recent decades but has declined in the past few years. In 1980, the number of bankruptcy filings was 331,264; by 2003, the total was 1.66 million, which then dropped to 1.22 million in 2012 (see Table 7.5). There are two forms of personal bankruptcy: Chapter 7 and Chapter 13. Under a Chapter 7 proceeding, all existing debts are wiped out. Chapter 13 is more complicated. It allows the filer an extension in time to pay off debts and frequently a reduction in the amount of obligations. Although income taxes survive after bankruptcy, penalties for late payment of them are not imposed under Chapter 13. The criterion for filing Chapter 13 is to make “best efforts” to repay creditors; under this proceeding, something approaching normal household operations including living expenditures and household maintenance items (painting, etc.) is expected to continue. There is generally a three to a maximum of five-year repayment period.

TABLE 7.4 How to Improve Your Credit Rating

Steps Explanation and Elaboration

Obtain and review a copy of your credit report These are the logical beginning steps. See whether the report is correct including whether payments have been made on time. If it is not correct, write to the credit bureau.

Pay all bills when due Self-explanatory. Reduce debt outstanding The lower the debt, the higher the credit score.

Do not consolidate debt. Limit the number of credit cards outstanding Having a few credit cards in force can increase

your score; having many more can reduce it. Plan future of credit Limit outstanding credit, for example, by spacing

cyclical purchases.

176 Part Two Ongoing Household Planning

A bankruptcy proceeding is supervised by a bankruptcy judge and involves a private trustee appointed by a U.S. government trustee from the U.S. Justice Department. It is the private trustee’s mandate to find as many creditor possessions as possible because payment is calculated on a fee-and-commission basis. The commission, contingent on the amount of assets found, provides incentive to uncover all assets. A bankruptcy proceeding stops evictions, default, foreclosure, and repossession actions for those notified, at least temporarily. Whether those who file will be able to keep their possessions will depend on the following factors:

• The state the person lives in. Most states mandate that a person in bankruptcy be left with a minimum amount of equity in a house, a car, and household possessions. The amount varies by state.

• The level of security of assets. A secured asset is one for which other assets have been pledged against a loan in case of default. For example, a house is pledged for a mort- gage loan. In the event of default, the creditor often has a legal right to that asset regard- less of bankruptcy. If loans are in good standing, the asset cannot be repossessed by that creditor.

TABLE 7.5 Bankruptcy Statistics Year Total Filings Business Filings Nonbusiness Filings

Consumer Filings as a Percentage of Total Filings

1980 331,264 43,694 287,570 86.81% 1981 363,943 48,125 315,818 86.78% 1982 380,251 69,300 310,951 91.78% 1983 348,880 62,436 286,444 82.10% 1984 348,521 64,004 284,517 81.64% 1985 412,510 71,277 341,233 82.72% 1986 530,438 81,235 449,203 84.69% 1987 577,999 82,446 495,553 85.74% 1988 613,465 63,853 549,612 89.59% 1989 679,461 63,235 616,226 90.69% 1990 782,960 64,853 718,107 91.72% 1991 943,987 71,549 872,438 92.42% 1992 971,517 70,643 900,874 92.73% 1993 875,202 62,304 812,898 92.88% 1994 832,829 52,374 780,455 93.71% 1995 926,601 51,959 874,642 94.39% 1996 1,178,555 53,549 1,125,006 95.46% 1997 1,404,145 54,027 1,350,118 96.15% 1998 1,442,549 44,367 1,398,182 96.92% 1999 1,319,465 37,884 1,281,581 97.12% 2000 1,253,444 35,472 1,217,972 97.17% 2001 1,492,129 40,099 1,452,030 97.31% 2002 1,577,651 38,540 1,539,111 97.56% 2003 1,660,245 35,037 1,625,208 97.89% 2004 1,597,462 34,317 1,563,145 97.85% 2005 2,078,415 39,201 2,039,214 98.13% 2006 617,660 19,695 597,965 96.81% 2007 850,912 28,322 822,590 96.67% 2008 1,117,771 43,546 1,074,225 96.10% 2009 1,473,675 60,837 1,412,838 95.87% 2010 1,593,081 56,282 1,536,799 96.46% 2011 1,410,653 47,806 1,362,847 96.6% 2012 1,221,091 40,075 1,181,016 96.71% 2013 1,071,932 33,212 1,038,720 96.90% 2014 936,795 26,983 909,812 97.12%

Chapter Seven Debt 177

As a practical matter, few homes, cars, and relatively inexpensive possessions are said to be repossessed in bankruptcy. Not all obligations are affected by bankruptcy proceedings. In addition to income taxes, divorce-related issues such as alimony, child care, and property settlements remain as do obligations stemming from fraudulent representations. Student loans also continue except for those considered an undue hardship. The federal government passed the Bankruptcy Abuse Prevention and Consumer Act of 2005. The result of this act has made filing for bankruptcy more difficult, particularly for the more lenient Chapter 7 form, which may be one reason for the decline in filings since 2003. Some key features follow.

1. A means test is established. If filers are in the top half in median income for people in their state and have income minus expenses of $100 a month or more, they must file under Chapter 13 and retire the debt over three to five years.

2. Filers must enroll in credit counseling and have a repayment plan from an approved agency within six months of the bankruptcy filing.

3. The act affirms the ability to keep pensions, IRAs, and prepaid tuition and college edu- cation plans.24

4. Under Chapter 13, the bankruptcy judge has the discretion to reduce the amount to be paid by up to 20 percent of the total.

5. The amount of debt for luxury items that can be expunged within a 60-day period of bankruptcy is limited; debts for cash advances that occur within a 70-day period are not eliminated.

6. Only $125,000 of interest in a homestead can be exempted if it was purchased within 1,215 days of the date of filing. (Adjusted for inflation, this amount is now more than $150,000.) Because some people seek to file in a debtor-friendly state, they must have lived there for at least two years prior to filing to take advantage of that state’s generous exemptions from bankruptcy for homes.

The credit counseling and the more expensive filing requirements are believed to discour- age bankruptcy filings. Clearly, bankruptcy is a fairly involved procedure. It has many advantages and disad- vantages, which we list here.


1. It provides relief from financial burdens.

2. It can eliminate worry and harassing calls from creditors.

3. It can stop removal of some assets temporarily or permanently.


1. Some assets may be taken.

2. Bankruptcy has a social stigma from bankruptcy. Information regarding it is a matter of public record.

3. It can result in employment rejection. Although discrimination because of bankruptcy is illegal, it could be difficult to prove.

4. It can contribute to a poor self-image.

24 If education funds are contributed at least two years before bankruptcy, an unlimited amount may be retained; if between one and two years, a maximum of $5,000 is allowed.

178 Part Two Ongoing Household Planning

5. A guarantor of the debt will be personally liable to repay it.

6. The money for any preferred repayments, for example, for friends and relatives, that take place within one year prior to bankruptcy must be turned over to the trustee.

7. Bankruptcy involves costs including legal fees, an expense that is optional but generally recommended.

Given these distinct advantages and disadvantages, the analysis of whether to declare bankruptcy can have aspects of an investment decision. The financial and behavioral issues in deciding a future course are discussed in the Practical Comment on when to declare bankruptcy.


Financial ratios indicate the relative degree of financial risk the household has under- taken including its ability to pay off obligations when they come due. In other words, these ratios can help the household to determine whether it is in or approaching a finan- cial danger zone. There are two broad approaches to establishing that risk. The first is based on the household’s assets and the amount of debt outstanding relative to those as- sets. The second is based on cash flow and the amount of interest expense and debt re- payments relative to those assets. Both are useful and, although the amount of debt outstanding is more often used by some as a benchmark of overall financial health, inter- est expense is more of a day-to-day cash flow consideration. The relevant ratios are ex- plained next.

Bankruptcy is a serious step that will remain as part of a person’s credit report for seven years (Chapter 7) or 10 years (Chapter 13). Should it be considered? For some the answer is simple. For those who have a large obligation and are unable to pay it, there is no choice. At the other extreme, some people have a short-term liquidity problem. Their total debts don’t amount to a great deal, but they are being pressed by creditors now and can’t repay. Those cash flow–strapped people should enter into negotiations with their creditors. Often an ex- tension of terms or consolidation and perhaps even a reduction in amount due or interest cost can be worked out. For people in debt, the threat of bank- ruptcy alone can be a persuasive negotiating tool. Hiring a financial planner or nonprofit credit coun- selor affiliated with the National Foundation for Credit Counseling (NFCC) can help. In many cases, a detailed household budget should be implemented. For others, bankruptcy is a kind of capital expenditure decision with strong pluses and

minuses. The size of the loans, whether they are se- cured or not, local state policies, whether valuable assets will be taken, and the ability to repay the loans are all factors that enter into financial consid- eration. The amount of current stress and its effect on the filers’ work and personal life should be weighed against the reduction of stress, but social stigma and possible self-image difficulties exist after bankruptcy. What it can come down to is whether people are willing and able to liquidate pension assets that may be insulated from creditors, cut back sharply on household expenditures for a time, or possibly take a second job. Help should be sought for emotional difficulties such as compulsive spending. These diffi- culties will not go away with bankruptcy. Placed in a simpler framework, avoiding bank- ruptcy is often best for people who can pay their creditors within three years.

Practical Comment When to Declare Bankruptcy

Chapter Seven Debt 179

Percentages Related to Debt Mortgage Cost as a Percentage of Income Mortgage debt is usually the largest obligation homeowners have outstanding. Mortgage payments, including real estate taxes and homeowner’s insurance, are customarily ex- pressed as a percentage of gross income. Lenders often use a 28 percent benchmark as a percentage of gross income as the limit to which they will extend credit (if they add all other debt charges and limit the total to 36 percent of gross income). However, the rate may be adjusted upward depending on circumstances such as living in a high-cost area such as the Northeast or the West Coast.

Installment Debt as a Percentage of After-Tax Income Installment debt is the normal way to repay credit card debt and loans taken for nonbusi- ness, nonmarketable investment purposes. Repayment of this debt is often compared with net salary (gross income minus taxes and other cash deductions from a paycheck). Keeping such debt under 20 percent of so-called take-home pay is often desirable, and a 15 percent limit is even more attractive. These benchmarks are particularly relevant when there are other types of debt outstanding such as mortgage debt.

Installment debt, % = Installment debt repayments

Net salary

Total Debt as a Percentage of Income Mortgage debt and related expense payments plus nonmortgage debt payments are com- bined and expressed as a percentage of net salary. Interest payments and real estate taxes are expressed on an after-tax basis with tax deductions assumed at the household’s marginal tax bracket. As we have discussed, most nonmortgage debt is not generally tax deductible and is, therefore, taken on a pretax basis. Total debt payments should be less than 50 percent of net salary.25 When investment income is a substantial contributor to cash flow, it may be added on an after-tax basis to net salary. We discuss the relevant ratios next.

percentage of Total debt as

income =

interest and principal Total nonmortgage

payments + interest 11 − t2 and

Total mortgage

principal payments + and homeowner’s

Real estate taxes 11−t2

insurance expense

Net Salary

where t tax rate and (1 − t) = expense presented on after-tax basis.

Debt-Related Ratios Debt Coverage Ratio This ratio measures contractual debt and payments against household cash flows from op- erations. Thus, its benchmark is the amount available after deducting normal household overhead expenses from take-home pay, not the take-home pay. The ratio measures how much higher available cash flow is than interest and debt repayment cost. The higher the ratio, the safer the household is against negative unexpected occurrences.

25 This figure differs from a bank’s screen for total debt of 36 percent in that it is based on after-tax, not pretax, and income. This formula expresses interest and real estate costs on an after-tax basis.

180 Part Two Ongoing Household Planning

College Age • If you’re thinking debt, debt, debt, how will I ever repay my college loans over time, don’t worry. If you plan ahead, you will be able to do so.

• Begin to establish a good credit record; it will pay future dividends.

• There are savers, and there are spenders that perennially have large non mortgage related debt. As a future college graduate with anticipated above average long term income, steer yourself over your life cycle into the first category.

Twenties • Start repaying your college debt on time.

• Don’t borrow large amounts of money unless you have a good reason to do so.

• Try to repay credit card debt when it is due before the interest rate eats you up.

• If you are susceptible to overspending, you should establish a simple budget and stick to it through life.

Thirties • Spend time examining the specifics of mortgage debt; you can save thousands of dollars.

• Recognize that debt isn’t inherently “evil.” If the reason for taking it out is for a good investment, such as getting an MBA, do so.

Forties • Look at your current debt level; the amount should be going down.

• Look at credit card debt rationally; pay it off or transfer it to a home equity line of credit if possible.

• If you still have problems with savings, engage in such tactics as leaving credit cards at home and “paying yourself first” by directing money from paychecks to savings.

Fifties • Your goal should be to pay off all nonmortgage debt as quickly as possible. Retire debt with the highest interest rate first.

• Try to pay down mortgage debt so that it is eliminated before retirement.

• If you continue to have trouble paying off debt, try using a detailed budget. For many, the idea of all that structure and effort will be sufficient to establish a fruitful effort.

Sixties • Look at your debt profile. If it doesn’t look good, do something about it before retirement.

• Don’t fall into a new credit card debt trap when you won’t have job-related income to pay it off.

Seventies and Beyond • If you don’t want to sell your home and you have been careful about using debt, consider a reverse mortgage to finance living costs later in life. Make sure you understand the terms of the loan or show it to a professional.

Life Cycle Planning Debt

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Chapter Seven Debt 181

The ratio adds back after-tax interest payments because both pretax interest and its effect on lowering taxes were deducted to arrive at cash flow from operations.26

Times fixed payments earned

= Cash flow from operating activities + interest payments 11 − t2

Annual total interest and debt payments

Note: Cash flow from operating activities = Cash flow after nondiscretionary and discre- tionary activities.

Debt as a Percentage of Total Assets This ratio measures debt in relation to assets, not cash flow. It is difficult to develop broad benchmarks for warning signs of excess financial leverage. When people are young, they may place almost all their resources in a down payment on their home and borrow the rest. In that circumstance, debt may compose 80 percent or more of their total assets. The ratio should decline over time because as people age other assets should accumulate, the home should appreciate, and the mortgage should be drawn down.27 If debt payments become onerous, securities could be sold to help repay the debt. For people who are middle-aged or older, a debt figure of less than 50 percent of total assets may be desirable.28

Debt as a percentage of total assets = Total debt

Total Assets

Current Ratio The current ratio compares current assets with current liabilities. Because these are assets and liabilities that will fall due within one year, the ratio of the two can measure people’s ability to pay off their debts as they occur. However, as mentioned in the chapter, the use of credit card debt as an alternative to having high precautionary liquid savings has some- what lessened the importance of this ratio.

Current ratio = Current assets

Current liabilities

With this knowledge of debt and ratios as background, I can address the Dan and Laura debt situation that follows the Life Cycle Planning section.

26 The formula could be modified to include lease payments or all fixed obligations in the denominator under the assumption that all of them must be funded or the household would encounter difficulties. 27 An alternative ratio would measure debt as a percentage of a house plus liquid assets. Having a significant amount of total assets in marketable securities can serve as support for this formula. 28 The asset to liability measure and a ratio measuring liquidity were the best predictors of insolvency. See Sharon A. DeVaney, “The Usefulness of Financial Ratios as Predictors of Household Insolvency: Two Perspectives,” Financial Counseling and Planning Journal 5 (1994): 15–24.

Back to Dan and Laura DEBT The meeting we had on debt was somewhat charged. Dan hated the thought of debt. Yet here he was with $20,000 in credit card debt at 18 percent cost and about $46,000 in educational loans at 6 percent from his undergraduate days. Both he and Laura under- stood that the house, the car, and Laura’s graduate school enrollment would require additional borrowing. Dan accused Laura of being too flip with money. He said that

182 Part Two Ongoing Household Planning

whenever they were short of capital, she was quick to flash a credit card, particularly for purchasing attractive clothes at the mall, and that she was oblivious to the thought that at 18 percent interest, the cost was very high. Laura appeared very sensitive to the accusation. She said that Dan was very picky and that if they had followed his recom- mendations, they would be living in a one-bedroom apartment in a poor neighborhood, counting their pennies. I was about to intervene. Their difference in point of view seemed to be affecting their personal relationship. Then both people caught themselves, looked at each other, and smiled. I had the feeling that they had been through this type of discussion many times before and that each appreciated that the other had a different point of view. Both were concerned about their debt and felt a little overwhelmed. They wanted me to help them decide how to approach their financing needs. They indi- cated that Laura’s parents were not charging interest on the loan to them and appeared willing and able to help them if they needed more capital—for example, to finance the purchase of a home. Laura mentioned that her parents viewed the loan as a gift and would apply the money against her share of her ultimate inheritance when they pass away. Significantly, I thought, Dan made no comment about this financing source.

Here’s the advice I presented to them: Borrowing can be a positive or a negative force in financial planning. Borrowing for capi- tal expenditures that improve income-earning abilities or for those that reduce ongoing costs can be highly effective. On the other hand, significant monies borrowed to support normal household expenditures over a period of time should be discouraged. It can lead to a dependence on debt and an ever-rising monthly interest and debt repayment schedule that can retard your financial planning. In other words, borrowing can make household operations more efficient more quickly, but it also can add to risk and potentially derail your plans. Your own situation contains both “good” and “bad” use of debt. The borrowing that Dan made for college enabled him to obtain knowledge and a degree that substantially raised his projected lifetime income. The credit card debt you owe cannot be justified in terms of interest cost or probably even the reason for which the money was spent. Over the next several years until Laura goes back to work, your budget will have to reflect more limited income and higher child rearing and educational costs. Here is my thinking. I understand that debt concerns were the reason you came to see me originally. I also know that the need to move on the recommended purchase of a home has only compounded the problem. The most attractive form of borrowing is home mort- gage debt. Its cost is relatively low, and it is tax deductible. I’m going to recommend that you finance 90 percent of the cost of the home when you purchase it, if such a loan is avail- able. (Many lenders require 20 percent down as the result of the 2008 mortgage meltdown, but some accept smaller amounts. You may temporarily have to pay a higher total interest cost to purchase insurance guaranteeing repayment of the mortgage.) That will result in your temporarily paying a higher cost to purchase insurance guaranteeing the lender repay- ment. That extra cost will exist until the combination of appreciation on the home and re- payment of debt works the debt-to-home-value ratio down to a more reasonable level. Even with the extra cost, the home is still your best form of financing. If you can get your parents to cosign the loan indicating that they will pay the mortgage if you don’t, you may be able to get the home at a regular interest rate. The approximate $65,000 gift from your parents should pay for the 10 percent down payment on the say $250,000 home, moving expenses, and half of Laura’s tuition. It can only enhance the return on Laura going back to graduate school. Explain to them that you’re doing this for tax reasons because the cost to borrow on the home is lower than the

Chapter Seven Debt 183

cost to finance a nontax-deductible educational loan. Use your existing investments to re- pay the $20,000 of credit card debt due and $7,000 of other debt due. The balance of edu- cational costs in two or three years could be financed by liquidating a portion of your investments. Finally, it was nice that Laura’s parents decided to forgive your loan of $20,000 from them. I believe that your use of credit cards as a form of debt should be limited. The cards should generally be paid off each month. In a few instances when you have a bulge pay- ment, say for an unplanned expenditure, you can keep the debt outstanding for a few months. It may still be less costly than other forms of borrowing for short periods of time. However, if you don’t have the demonstrated discipline to pay it off over a few months, then I recommend no credit card debt be taken out at all. Keep Dan’s existing college debt for now. This is a summary of the transactions in today’s dollars over a period of years,

Cash Inflows

Sale of existing investments $72,000 Parental gift $65,000 Total $137,000

Cash Outflows

Repayment of credit card and other current debt due $27,000 Payment of graduate school costs $80,000 Down payment on home $25,000 Moving expenses $5,000 Total $137,000

Net Cash Flow $0

College Student Case Study and Review: Amy and John DEBT Both Amy and John knew there was no alternative to accumulating debt. However, they still felt that borrowing is not only a future burden but also an unhealthy development. I decided to meet that concern head on. I explained that debt is neither good nor bad; it de- pends on each situation. Taking out debt to finance normal household costs because you’re spending more than you’re earning is clearly bad. Borrowing money to finance your col- lege education as the two of you have done is good. The amount owed should easily be paid back in the future by the higher income most college graduates receive compared with the incomes earned by those without a college degree. Nonetheless, you should become familiar with debt.

Risk and Leverage There are two types of leverage, operating and financial.

Operating Leverage Operating leverage has nothing to do with debt. It has to do with volatile company opera- tions often caused by high fixed costs. If necessary costs are high, a shift in revenues up or down causes cash flows to move sharply. When they decline, they add to risk.

184 Part Two Ongoing Household Planning

Financial Leverage Borrowing monies increases fixed costs as interest expense rises. It also offers the oppor- tunity to make purchases of useful assets more quickly. If the borrowing goes into efficient assets, say a dishwasher that frees income-producing work time, it can raise household returns. However, as fixed costs rise, risk due to unforeseen circumstances rises as well. As discussed in this chapter, financial ratios for debt help compare your figures with overall standards and allow you to measure your current figures against those for prior years.

Mortgages Mortgages are loans secured by real property. That means that the property can be sold by creditors in the event of nonpayment. Therefore, it is safer for lenders than unsecured debt, which is backed only by the borrower’s obligation to repay. The mortgage loan process includes the application, the assessment of the borrower’s quality, the home appraisal, the commitment, and the closing. Principal payments on mortgage debt lessen over time as debt is paid down. Over this period, the percentage allocated to interest payment declines and the percentage for princi- pal payment rises. (The total payment can be calculated simply, as shown in this book.)

Types of Mortgage Amy and John, there are two types of mortgage payments: fixed rate and adjustable rate. A fixed-rate mortgage is one whose interest rates remain stable over time. An adjustable-rate mortgage rate fluctuates with overall market interest rates. The upper limit on the rate may be capped.

Advantages Disadvantages

Fixed Rate •   Safety and peace of mind from  stable payments.

•  Higher cost

•  Ability to lock in rate. •  Lender assumes interest rate risk. •   Ability to refinance when rates 

are low. Adjustable Rate •  Lower interest cost. •   Aside from a possible ceiling on the rate 

that can be charged, no protection against higher interest rates.

•   Ability to take advantage of low  initial rates when available.

•  Borrower assumes interest rate risk

•   Easier to qualify for more home  financing and therefore purchase due to often low initial rates.

Home Equity Loans These are also loans secured by the home. A home equity loan is a second mortgage that allows its lender to follow the first mortgage owner in reclaiming assets if the borrower defaults.

Home Equity Line of Credit This is like a home equity loan but the money does not need to be borrowed at the time of signing. The line represents how much is available to be taken out when the borrower chooses.

Chapter Seven Debt 185

Other types of debt are:

• Credit card debt. Generally used for purchasing consumer goods. Rates are high and non-tax deductible.

• Margin debt. Debt tied to the purchase of financial securities. Rates are low and tax deductible to the extent of interest and dividend income.

• Bank loans. Interest on them not tax deductible.

• Credit unions. Associations that lend money to their members. Rates may be highly competitive.

• Pension loans. Loans against retirement funds. They are limited to 50 percent of the amount or $50,000, whichever is lower.

• Life insurance loans. Loans against cash values of insurance.

• Education loans. Loans from federal agencies and colleges or universities that often have favorable rates, especially those based on need.

• Loans from friends and relatives. Can be cheap but watch the friendship angle.

Credit Reports A credit report is the factual printout and evaluation of a person’s creditworthiness. The increase in mortgage loans to borrowers with low credit scores in the years 2000–2007 contributed to the 2008–2009 recession. Subsequently, required scores have been raised. Individual credit reports can be obtained annually at no charge from the three credit bu- reaus: Equifax, Experian, and TransUnion.

Financial Difficulties and Bankruptcy There are a few remedies when financial difficulty results in the inability to fund current or projected debt payments. A consolidating “super loan” replacing other small ones may be appropriate. Other alternatives include increasing income with an additional or new job or cutting back on expenses, which is typically the most fitting solution. In some cases, a negoti- ated reduction in interest rates or amounts due may be reached with the lenders. When these approaches are insufficient, bankruptcy may be considered. There are two types of bank- ruptcy: Chapter 7 and Chapter 13. Chapter 7 eliminates all debt. Chapter 13 offers a reduction in debt and an extension of time to repay the balance. Those who are in the top half of their state’s median income may not qualify for Chapter 7. For either chapter, filers must enroll in a credit counseling course and may be able to keep certain assets including their home. Bankruptcy provides relief from financial burden, eliminates worry, stops creditor calls, and can in some situations prevent certain assets from being taken although others are taken. Various fees are required to file for bankruptcy. Entering bankruptcy still has a social stigma although it is not as prevalent as it once was.

Summary Debt is a financing tool that can enhance investment opportunities and provide earlier use of assets when used properly. When overused, it also can result in financial difficulties. The chapter details when and how to use this tool.

• There are two types of leverage: financial and operating.

• Mortgages, which are a relatively low-cost way to obtain funds, come in fixed- and variable-rate forms.

• Credit card debt can actually be a favorable way to obtain funds, but too often it is used inefficiently.

186 Part Two Ongoing Household Planning

• Consumer protection laws require safeguards and mandate disclosures that can assist borrowers to maintain favorable credit ratings.

• Bankruptcy is an alternative that creates opportunities but also has substantial negative ramifications.

• Financial ratios discussed here provide objective benchmarks of financial health with regard to debt levels.

Key Terms adjustable-rate mortgage, 163 bankruptcy, 175 closed-end retail credit, 157 credit report, 173 financial difficulties, 175 financial leverage, 154

financial risk, 153 fixed-rate mortgage, 163 home equity loan, 166 hybrid ARM, 164 interest rate, 155 long-term debt, 159 margin debt, 169 mortgage, 159

open-end credit, 157 operating leverage, 153 operating risk, 153 rationed borrowers, 158 secured debt, 159 short-term debt, 159 unrationed borrowers, 158 unsecured debt, 159

bankrate.com Borrowing Sections on mortgages, automobile loans, and credit card debt are included on this Website. It also contains information about rates and trends and has credit and loan calculators.

interest.com Mortgages The Website lets the consumer shop for mortgages and find a lender. It also has mortgage calculators and lets users track mortgage rates. It has sections on refinancing and other types of loans such as auto, home equity, and credit card.

abiworld.org American Bankruptcy Institute This site serves as an online resource for bankruptcy information and news. Bankruptcy statistics, education information, online newsletters and publications on bankruptcy, and a search tool for finding an attorney experienced in bankruptcy mat- ters are provided. (Access to some data requires a paid membership.)

finance.yahoo.com/topics/credit-debt/ Yahoo’s Loan Center The loan center offers information on mortgage, home equity, and auto loans.

creditforums.com Credit Forum A “community of credit and personal finance experts” answers questions on credit- related issues.

nfcc.org National Foundation for Credit Counseling This site provides information to help find member agencies staffed by professional Certified Consumer Credit Counselors who can provide personal assistance to people who need help with stressful financial situations.


Chapter Seven Debt 187

annualcreditreport.com Annual Credit Report AnnualCreditReport.com is a centralized service for consumers to request annual credit reports. On this Website, consumers can request and obtain a free credit report once every 12 months from each of the three nationwide consumer credit reporting companies: Equifax, Experian, and TransUnion.

Other Websites offering online credit reports, credit improving tools, and advice include

equifax.com Equifax

experian.com Experian

transunion.com TransUnion

Questions 1. What is debt’s role in the household? 2. What is the difference between debt and fixed obligations?

3. What is the difference between debt and intangible liabilities?

4. Contrast operating risk and financial risk.

5. Why is operating leverage as it pertains to risk important?

6. Harry was deciding on the separation of outlays into nondiscretionary and discretion- ary. What advice would you offer him on the division as it relates to risk?

7. What is APR and why is it important?

8. List and explain the borrowing factors.

9. Contrast the strengths and weaknesses of a fixed-rate mortgage with those of a variable-rate mortgage.

10. Alexis wants to buy a large home relative to her income and thinks that she may not qualify for a mortgage for 80 percent of the price. She expects interest rates to rise and anticipates staying in the home for many years. Explain the strengths and weak- ness of fixed- versus variable-rate mortgages for her. Indicate which one you would select and why.

11. Why are adjustable-rate mortgages generally cheaper than fixed-rate mortgage loans?

12. When is a home equity loan better than refinancing a first mortgage?

13. Credit cards are a grossly inefficient way to borrow money. True or false? Explain and discuss their advantages.

14. Why borrow using secured debt?

15. Pension loans save you money because you pay yourself back. True or false? Explain.

16. Are loans from friends and relatives a good practice? Explain.

17. What borrowing mechanism provides the lowest cost. Why?

18. How can you improve your credit? Indicate the specific steps to do so.

19. Jeremy is in financial difficulty. He owes $5,000 and cannot pay it back now. Should he declare bankruptcy? Why? What do you think he should do?

20. In calculating the ratio times fixed payments earned, after-tax interest payments are added back in the denominator. Why?

188 Part Two Ongoing Household Planning

Problems Dorothy has the following projected cash flows: income, $65,000; fixed operating costs excluding interest, $44,000; variable outlays, $7,000; interest cost, $5,000; and repayment of debt, $6,000. Does Dorothy have high operating leverage? Calculate what a 15 percent higher and 15 percent lower income would do to profitability.

For the $8,000 loan John needed, he was given a choice of in loans with the following characteristics.

a. $1,200 in interest paid at the end of the period.

b. $1,200 in interest paid at the beginning of the period.

c. $1,200 paid equally over the period with part of the principal retired each month.

Calculate the interest rate paid. In part (c), calculate using both the approximate method and the actual cost method assuming a one-year loan retired in 12 equal monthly install- ments of interest and principal.

Melinda has a 15-year fixed-rate mortgage for $150,000 at a 6.5 percent rate. Calculate her monthly mortgage payments.

Martha has seven years remaining on her $160,000 mortgage, which has a 7.5 percent rate. She would have to pay $4,500 to refinance. Martha expects to live in the house for another five years. She is in the 33 percent marginal tax bracket and can earn 10 percent after tax on other uses for the money. If the mortgage rates have declined to 6.5 percent, should she refinance?

How much would a person save by borrowing money at 6 percent for a home equity loan versus 18 percent for a credit card loan. Assume a marginal tax bracket of 30 percent.

Given the following statistics, calculate the mortgage cost percent.







Elena is in the 28 percent bracket and has the following real estate and nonreal-estate- related costs.


Nonmortgage interest and principal $ 4,000 Mortgage interest 15,000 Mortgage principal 7,000 Real estate taxes 8,000 Homeowner’s insurance expense 2,000 Net salary 70,000

Calculate total debt as a percentage of income. Is it satisfactory?

Louis had the following cash flow items:7.8

Cash flow from operations $40,000 Interest payments 6,000 Total interest and debt payments 9,000

If Louis is in the 30 percent tax bracket, how many times are fixed payments earned?

Annual mortgage interest $ 9,000 Annual principal payment 2,000 Annual insurance and real estate taxes 8,000 Yearly gross income 120,000

Chapter Seven Debt 189

The Moores recently found out that they can reduce their mortgage interest rate from 12 percent to 8 percent. The value of homes in their neighborhood has been increasing at the rate of 7.5 percent annually. If the Moores were to refinance their house with $2,000 in closing costs in addition to the mortgage balance ($120,056) over a period of time to coin- cide with their chosen retirement age in 22 years, what would the monthly payment be for principal and interest (closing costs are going to be added to the mortgage)?

a. $853.43.

b. $895.60.

c. $945.34.

d. $967.86.

e. $983.99.

A young couple would like to purchase a new home using one of the following mortgages:

Mortgage no. 1: 10.5 percent interest with 5 discount points to be paid at time of closing

Mortgage no. 2: 11.5 percent interest with 2 discount points to be paid at time of closing

Assuming the couple could qualify for both mortgages, which of the following aspects should be considered in deciding between these two mortgages?

1. gross income.

2. estimated length of ownership.

3. real estate tax liability.

4. cash currently available. a. (1) and (2) only.

b. (2) only.

c. (2) and (4) only.

d. (4) only.

e. (1), (2), (3), and (4)

A CFP® professional meets with two new clients who would like advice about their mortgage. In the review, the CFP® professional finds that their essential expenses exceed their income. Mortgage rates have come down significantly and they intend to refinance their current 30-year mortgage to a 15-year mortgage. Their payments will be higher than their current payment. However, they will pay off their mortgage 5 years earlier than the current amortization schedule allows. What should the CFP® professional do?

a. Suggest they stay with their current mortgage, as the higher interest rate is tax deductible.

b. Suggest they refinance to a 30-year fixed mortgage and begin funding savings.

c. Suggest they refinance to the 15-year mortgage, which would reduce the amount of interest paid over the life of the loan.

d. Suggest they meet with their mortgage broker.




CFP® Certification Examination Questions and Problems

190 Part Two Ongoing Household Planning

Case Application DEBT Part 1 Richard and Monica have diametrically opposite points of view on debt. Richard views debt as an opportunity to generate cash to make up for past investment losses. He has asked you whether he should remortgage his house and place the proceeds in the stock market. He says the present time may be appropriate to refinance because market rates for mort- gage loans of 6.5 percent are well below his mortgage rate of 8 percent. He wants to use an adjustable rate that provides an even lower 4 percent rate for the first year with rates there- after 2 percent above the five-year Treasury rate. Richard wants a 30-year mortgage because he said he doesn’t expect “to go anywhere” and the annual repayments would be low. He said he was thinking about buying a new car. While the existing one worked well, he was tired of it. If cash flows get tight, he isn’t at all averse to using credit card debt. He says that whereas credit card rates are high, the overall impact is not great and “people manage to pay money back.” Monica has listened quietly to Richard with a pained expression on her face, occasionally shaking her head. She says she is afraid of taking on more debt and wants a budget to limit spending of all types.

Case Application Questions 1. What do you think of Richard’s idea of borrowing to place money in the stock market?

2. Do you think the couple should refinance their mortgage?

3. Should they use the adjustable-rate mortgage offered?

4. What is your recommendation on a 30-year loan?

5. Should the couple buy a new car?

6. What do you think of Richard’s view of debt?

7. Do you agree with Monica’s point of view?

8. How would you treat the disagreement between Richard and Monica?

9. Complete the debt and future budgeting part of the plan.

Part 2 Brad and Barbara say they use credit cards all the time. They always intend to pay them off by the end of the month, but they often don’t. In fact, their credit card debt has been rising recently.

Case Application Questions 1. Is this pattern common?

2. What is your recommendation?

Appendix I

Borrowing Theory: Risk and Equilibrium In a world with perfect capital markets without risk, households can borrow or lend at the same rate. Either borrowing or lending or neither will be selected. People borrow when their capital budgeting opportunities or present consumption needs exceed their existing

Chapter Seven Debt 191

cash flow. Without risk in the marketplace, a household can borrow as much as it wants at a low risk-free rate. It would borrow until the point that the return from capital expendi- tures or other forms of investment equaled the borrowing cost. Of course, no such world exists. When risk and transaction costs are introduced, the framework changes dramatically. Then the cost of borrowing will be different than the re- turn available on external investments such as marketable securities. What we pay for the money we borrow depends on the amount of risk we undertake. The greater the uncer- tainty, the higher the market interest rate charged. We call the expense we pay in borrow- ing money the cost of debt. Let’s trace how debt is used under these circumstances. Whether the household will be saving and investing or will have a need to borrow funds will depend on its marginal rate of time preference. This marginal statistic is the rate that makes postponed future con- sumption expenditures possible with savings and investing equal in appeal to spending the money today. Each household has its own value system and therefore its own discount rate. Of course, the marginal rate will be influenced by the amount of cash flow that the household generates as well as its desire for additional goods. The marginal rate of time preference will be compared with the cost of debt and the returns on internal and external investments.29 Debt may be used for consumption when its cost is lower than the marginal rate of time preference and for investment when the cost of debt is lower than the projected returns on investment. What makes the analysis more complex is that investment consumption and borrowing patterns will be affected by the household’s tolerance for risk and that tolerances can differ materially among households. For example, even without the need to borrow to buy a used dishwasher from a private party, one household may be willing to pay 50 percent of origi- nal cost. In contrast, another household, more fearful of the possibility that dishwasher repairs would be needed shortly after purchase and therefore are more risk averse, would require a higher return on the durable good. Consequently, its member-owner might offer to pay 25 percent of original cost. The impact of risk on consumption also would vary by household. We might assume that higher risk would result in more saving, but this may not always be true. If two house- holds were to be exposed to the same risk of a possible debilitating illness, one might lower its original marginal rate of time preference to generate savings for this possibility. Another household, however, might raise it, preferring to enjoy life today while its mem- bers know they are still healthy. Borrowing and raising household risk can increase the required return on investments, the extent of which also can vary by household. We can conclude by saying that borrowing may be used when its cost is below the risk-adjusted marginal rates of time preference and of invest- ment return. Clearly, the higher the cost of debt, the less likely it is that borrowing will be used.

Appendix II

Consumer Protection Laws A variety of laws protects consumers in purchasing. They are entitled to fair disclosure of information that is relevant for purchase. Consumers can sue anyone who violates laws. The government helps by reviewing the activities of manufacturers, sellers, and lenders, for example. See the following for the rights of the buyer in selected areas. They are all

29 Those for household production currently versus those for traditionally liquid investments such as stocks and bonds.

192 Part Two Ongoing Household Planning

subchapters of the Consumer Credit Protection Act (CCPA), which is enforced by the Federal Trade Commission.

TRUTH IN LENDING ACT When consumers are provided credit under the Truth in Lending Act, the lender is obli- gated to disclose such things as the cost of credit using the objective APR (annual percent- age rate), annual and late payment fees, the actual amount being provided, and so on. Damages are measured by the difference between actual charges and those indicated misleadingly as a lower charge.

FAIR CREDIT BILLING ACT If there is a dispute about the amount owed, the Fair Credit Billing Act allows consumers to write the creditor explaining the difficulty whether due to errors in calculating amount due, orders never received, returns never credited, and so on. The comments must be re- ceived within 60 days of the bill. Consumers can withhold the amount in dispute. The lender must resolve the claim within 90 days of receipt of the letter. The consumers’ credit isn’t affected during this period. Consumers whose credit cards are stolen or permanently lost are liable for a maximum of $50. If they report the loss before unauthorized transactions are made on their credit cards or if the loss involves their credit card number but not the card itself, consumers have no liability for any unauthorized charges.

FAIR CREDIT REPORTING ACT When applying for credit, the credit reporting agency must check the information, estimate the applicant’s ability to handle the credit, and investigate the applicant’s credit history. Adverse information more than 7 years old should be deleted except for information about bankruptcy, which is available to lenders for 10 years. The credit-reporting agency is obligated to keep this information current and accurate. The information generated may be used for only narrowly selected reasons such as for credit or for employment.

EQUAL CREDIT OPPORTUNITY ACT Under this act, no one can be discriminated against on the basis of race, sex, marital status, or national origin.

FAIR DEBT COLLECTION PRACTICES ACT The Fair Debt Collection Act limits debt collection procedures to those that are fair. The debtor must be notified of background information on the debt and given 30 days to report disputes.

CREDIT CARD ACCOUNTABILITY RESPONSIBILITY AND DISCLOSURE ACT This act amends the Truth in Lending Act to prescribe enhanced disclosures to consumers, limit related fees and charges to consumers, increase related penalties, and establish con- straints and protections for issuance of credit cards to minors and students.

Chapter Seven Debt 193

DODD-FRANK WALL STREET REFORM AND CONSUMER PROTECTION ACT This act creates a new Bureau of Consumer Financial Protection within the Federal Reserve Board as a supervisor for certain financial firms and as a rule maker and enforcer against unfair, deceptive, abusive, or otherwise prohibited practices relating to most con- sumer financial products or services.

ADDITIONAL LAWS Other selected laws are briefly summarized next. They may vary by area.

Canceling a Purchased Item If consumers change their minds about a purchase, a federal cooling-off period allows them to cancel such things as a home improvement loan or sales for more than $25 if the sale didn’t take place at the proprietor’s place of business. States have different cooling-off periods. Exceptions are made for custom purchases.

Warranties Federal law refers to many types of warranties, which are also known as the product pro- vider’s guarantees to consumers. Under implied warranties that are not stated by the provider, the law implies that a product must perform as indicated and fit its purpose.

Consumer Leasing Act The Consumer Leasing Act applies to leases of four months or more for a variety of con- sumer goods. Consumers must receive information that permits comparison with other competing leases and with purchase of an item. Consumers must be given information such as the amount due on signing, total amount of payments, any other expenses, warran- ties on the good, fees for default or late payment, information on normal wear and tear, and the terms of any purchase option at the end of the lease. Advertising of a lease must dis- close some of this information.

Student Loan Defaults When in default, the U.S. Department of Education will notify credit bureaus, tax refunds may be withheld, collection costs may be assessed, borrowers’ wages may be attached, and they may be sued. When there are special circumstances for nonpayment, extensions may be given and, less often, partial or full elimination of the loan may occur.

Appendix III

Privacy Privacy is the ability to keep information about consumers free from unsanctioned exami- nation. Privacy has become a more significant problem because of unauthorized tapping into information on computers and through communication via the Internet. One outcome of carelessness about safeguards can be identity theft, which is discussed in Appendix IV. The Financial Modernization Act of 1999, known as the Gramm-Leach-Bliley Act (GLB Act), helps protect people who have information that resides at financial institu- tions. The GLB Act applies to all financial institutions that gather and release financial

194 Part Two Ongoing Household Planning

information, not just those that hold information for their own customers. Financial institutions must design, implement, and shield customer information. The act pro- tects people against those who would acquire this information falsely, called “pretex- ting.” The law requires financial institutions to notify and inform customers of their practices; customers have the right to restrict some institutional dissemination of their information. To protect themselves, consumers should follow the rules discussed under identity theft in Appendix IV. They shouldn’t provide personal information unless they are sure of the legitimacy of a company and the representative’s position with it. Ask companies about their safeguards. If statements don’t arrive on time or are erroneous, take immediate ac- tion. Safeguard personal information and tear up or shred old valuable financial informa- tion including checks, credit card information, and so on. Add passwords to financial information and keep information private by using uncommon password numbers. Consumers should check their credit rating from each credit rating agency every year. If pretexting (obtaining information by using a false identity) has occurred, they must follow the guidelines under identity theft. Financial advisors should have a written plan to safeguard client information. The plan should be appropriate to the amount and sensitivity of the information they have. The plan should include the following:

1. At least one person should be in charge of the effort overall or by area.

2. The risks to the client should be assessed.

3. A safeguard system should be established and monitored with outsiders consulted when appropriate.

4. The program should be reviewed and updated as needed.

Included in the program are:

1. Checking references for new hires.

2. Training employees in basic safeguards.

a. Lock rooms.

b. Require employees to become familiar with and sign a confidentiality agreement that includes abiding by established security standards.

c. Establish passwords on computers and change them periodically.

d. Don’t give out information unless confident that the request for it is authorized.

e. Implement a “need-to-know” policy for internal employees.

f. Impose disciplinary proceedings on violators.

3. For information systems:

a. Store information in secure area.

b. Protect information against fire, flooding, and other hazards.

c. Keep information away from machines having an Internet connection.

d. Keep information transmission secure.

e. Erase all data containing customer information that is no longer needed.

f. Back up all data.

In line with the GLB Act, the SEC requires that advisory companies notify clients about their policies and implement safeguard policies including nondisclosure of nonpublic personal information to outsiders until clients have an opportunity to refuse its dissemination.

Chapter Seven Debt 195

Appendix IV

Identity Theft Identity theft occurs when a person or group steals your personal information and repre- sents themselves as you, generally for purposes of financial gain. They can illegally as- sume your name and use your Social Security number, address, credit card number, date of birth, or other information. They can do this by going through trash, stealing wallets and purses, accessing credit card numbers, posing as legitimate service companies, and so on. Their tampering can result when you make a one-time expenditure or withdrawal and sys- tematically use your information until they have been identified. Some actions to protect yourself include:

1. Check your credit and the charges on individual credit cards. As discussed, you can re- ceive one credit report per year from each credit bureau at no charge. Consider purchas- ing a credit monitoring service that has a record of broad-based purchase information.

2. Notify your vendors and other creditors if expected bills have not arrived.

3. Follow up if you are denied credit.

If you have identified illegal activity:

1. Notify credit card companies or other relevant parties immediately of lost or stolen cards. As mentioned, your losses may be restricted to a maximum of $50. If your credit card number but not the card has been stolen, you are not liable for unauthorized use.

2. If checks are stolen or counterfeited, stop payment, change your bank account, and no- tify ChexSystems (1-800-428-9623) or another check verification service with which your individual bank does business.

3. Place a fraud alert on your credit card reports with any one of the credit reporting com- panies listed in this chapter.

4. Refuse to give personal information such as Social Security numbers over the phone or online. To check if it is a legitimate vendor such as your bank, call the general number and confirm the authenticity of the representative.

5. Tear up or shred sensitive material before throwing it out.

6. Don’t carry your Social Security card with you.

7. Take precautions to protect your computer-related files and communications.

8. Change bank accounts, credit cards, etc. Avoid new passwords related to your tele- phone or Social Security number, mother’s maiden name, or date of birth.

9. File a complaint with the Federal Trade Commission, which is the federal clearinghouse for identity theft.

10. File a report with the local police in the precinct where the theft occurred.

Advisors’ safety factors include:

1. Avoid receiving or sending sensitive client information via email.

2. Update virus protection software regularly to protect against intrusions.

3. Lock up sensitive hard copies of client information.

4. Shred all discarded client information.

5. Close down computers at the end of the day and use uncommon passwords to access.30

30 For other computer-related protection information on identity theft, such as sample letters and forms for victims of identity theft to limit the damage that is caused, see the Federal Trade Commission’s advice at consumer.gov/idtheft

Part Three

Portfolio Management

1 The home is a household investment as well and as such, is dealt with for comparison to other household assets and for aggregate household decision making in this chapter. However, the homes importance as part of the real estate sector and its link to external real estate investments merited it be treated as a separate chapter.

8. Household Investments 9. Real Estate and Other Assets

10. Financial Investments 11. Risk Management

These four chapters deal with portfolio management, the household’s overall invest- ment function. The household is typically thought of as having two choices in employing its cash flows. The first choice is to spend the money on current living needs and desires. The second is to save and invest the money, keeping it in reserve for future deployment. Actually, there is a third choice: to spend it on capital items. Capital expenditures are outlays that are both used today and benefit future periods. An example is the purchase of a new car, which will last for many years. We can call these outlays household investments, which make the household operate more efficiently or provide extended pleasure for its members. They are the subject of Chapter 8.1

Chapter 9 principally discusses real estate. It is separated into the home and other real estate. The home is often both a capital expenditure in its role as a shelter and a principal long-term investment for the household. Other real estate represents independent investments that generally provide income and price appreciation. The chapter also details and evaluates in summary form other assets incorporating com- modities and gold as investment alternatives. Those cash flows that are not spent currently but are reserved for future use are typi- cally placed in financial vehicles such as stocks, bonds, and mutual funds. They are called financial investments and are discussed in Chapter 10. They stand in contrast to what we can call in aggregate nonfinancial investments as presented in Chapters 8 and 9. Investments cannot be discussed solely in terms of returns. The household is subject to a variety of risks both for financial and nonfinancial assets. The general principles of investment risk and risk-return principles are explained in Chapters 10 and 11. Chapter 11 focuses on insurance, perhaps the best-known risk manage- ment tool. Life insurance alternatives are presented in detail in that chapter. These chapters should enable you to understand financial investments as well as to appreciate the broader scope of investments the household makes and the approach to protecting them. Total portfolio management, a method of resolving household deci- sion-making problems that integrates both financial and household investments and incorporates risk, is discussed in this Part and elaborated upon in Part Seven.


Chapter Eight

Household Investments Chapter Goals

This chapter will enable you to:

• Make better choices by recognizing that household assets and investment planning are broader than believed.

• Differentiate a typical household cost from a capital expenditure.

• Become more effective in decision making by employing total portfolio management (TPM), the household’s all-asset approach.

• Benefit from linking household outlays on durable goods with business capital expenditures.

• Apply methods for calculating returns on capital expenditures.

• Establish the advantages of owning a home.

• Determine whether to buy or lease a home or car.

• Utilize the knowledge that your salary is often your largest household asset.

Dan felt he has to have a “status car.” Laura was concerned about her family and her career. She thought of pursuing a Masters degree.

Real-Life Planning

At a periodic meeting, Ken asked the advisor if he could help him become better informed in financial matters. Ken was a former radio announcer who made his living doing voice- overs on television and radio commercials. He had at least 10 different “voices” and could adjust easily to the needs of the particular situation. His most popular voice was used by major national sponsors who provided him a payment every time it was repeated. Ken went to many auditions and ended up being cast on one of every five jobs for which he applied. Like many creative people, Ken had little interest in financial matters. He was, however, very curious and intelligent and didn’t mind being argumentative. Something he read in a finan- cial magazine had piqued his interest. It was a statement that appliances were household assets. He had always regarded them as expenses. He wanted to know what the advisor thought was the proper answer. The advisor knew that the answer would have to be simple and practical; otherwise, Ken’s eyes would move from side to side, signaling that his interest had been lost. The advisor told him that by one measure, he was technically correct. The calculation of the country’s output, gross domestic product (GDP), doesn’t include appliances or any

Chapter Eight Household Investments 199

other individual purchase as a household asset but does include the house itself. The same item purchased for a business (for example, a car or a television set) would be treated as an asset. However, the advisor indicated his strong belief in separating asset purchases (money spent for items that had usefulness over extended periods of time) from other outlays. The advisor explained to Ken the idea and the benefits of treating the household as a form of business. He mentioned that a large part of a household’s operations, those not pertaining to pleasurable activities, closely resemble a business. The appliances purchased could be used to save money or time. Time could be used to earn money. Ken would have more time for auditions, which would likely raise his income. Ken nodded but asked about a television. How isn’t that an indulgence, an expense? The answer was that the television might not boost the cash flow of the household, but it could add to the enjoyment of its members. Even a household work-related appliance not used for earning income could benefit the household by adding to leisure time. In addition, the television was an asset that had an identifiable fair market value. The advisor mentioned that return on investment techniques can be used to decide whether to purchase work-related assets, but more subjective measures might have to be used for those related to pleasure. The advisor said the key for outlays that aid household activities for a longer period than the current one is to treat them as investments. They should be segregated on current cash flow statements and in thinking about when future outlays will become necessary again. In that way, he should treat them separately just as a business does. The advisor said that these expenditures with multiyear benefits could be called capital expenditures. Ken flashed a wicked smile and asked for a financial rule of thumb in deciding whether to make or reject a work-related outlay for an appliance. The advisor responded with a rough rule for appliances that had around a five-year life: If the benefits exceeded the outlays within three years and were expected to continue significantly beyond that period, make it. Ken, employing what sounded like his 11th voice, which was eerily similar to that of former President Reagan, said, “Thanks, I understand what you are saying.”


Household investments are the assets the household possesses that are often overlooked or that have less time devoted to them than to more glamorous stocks and bonds. This is ironic because the average household’s assets in this area often exceed those for market- able financial securities. Consequently, efforts to improve decision making in this area can be highly productive for people. Said differently, capital expenditures and capital budget- ing as related to investments are as important to a household as they are to a business. In this chapter, we explain how to identify and value household investments in order to plan properly for their purchase and use. We do so by separating the chapter into four parts: defining and detailing household investments, examining the decision process, ana- lyzing major capital expenditures, and evaluating the leasing alternative. The chapter includes appendixes that extend the material.


The investments the household makes can be separated into two major categories: finan- cial and nonfinancial assets. Financial assets are those whose ownership is represented and traded solely through pieces of paper. Financial assets often maintain or increase in value over time, particularly when the cash they generate is reinvested. Often financial as- sets are fully marketable. Fully marketable assets, also known as marketable securities, are those that can be sold currently in a public forum for fair value at low transaction costs.

200 Part Three Portfolio Management

Examples of fully marketable financial assets are stocks and bonds. They are what we typically put our savings into. We discuss them in the next chapter. Nonfinancial assets are all the other assets the household possesses. They can be seg- regated into real assets, human-related assets, and other assets. Real assets are items that we can see or touch that have market value. Included are a person’s home and the posses- sions in it such as the furniture, household appliances, and the car parked outside. Sometimes these real assets are called tangible assets, physical assets, or hard assets. Real assets are generally used in the household currently whereas financial assets may be reserved for future use The term durable goods is more specific. For our purposes, it applies to household possessions. We use that term frequently in this chapter. Real assets, a broader term, can be separated into real estate, commonly the home, and durable goods. Aside from their physical features, real assets differ from financial ones because real assets generally decline in value over time. That deterioration may be due to changes in physical, technological, or fashion appeal over extended periods. A partial exception is the home, which, if maintained properly, can appreciate, at least for a relatively long time. The second category of nonfinancial assets is human-related assets. They are items that derive their value from particular people. In personal finance, we are principally con- cerned with assets in this category that generate income. For example, strength and beauty can be considered assets, but they don’t qualify unless they produce cash flows. People most commonly generate income directly through their work efforts. We can call this in- come-earning ability a human asset. Closely allied are corporate pensions and government pensions such as Social Security, which are often based on work efforts.2 Anticipated gifts and bequests represent another area that we include because they are most often received through human relationships with either family or friends. Human-related assets are sometimes called intangible assets because many—such as a Social Security right, a projected inheritance, or human education—cannot be touched. Another reason that they are termed intangible is that they are often nonmarketable— they cannot be sold to others, and, in any event, placing a fixed value on them may

Factor Financial Real Estate Durable Goods Human† Human Related

Practical example

Stocks, bonds Home, residence Auto, furniture Job Pension

Marketability Fully marketable Fairly marketable Fairly marketable Nonmarketable Nonmarketable Valuation over time

Increases in value‡

Increases in value; cost for upkeep

Declines in value Generally declines in value

Increases and then declines in value§

Use For future use For current use For current use For current use Varies Associated costs Little or none Upkeep Upkeep Food, clothing,

shelter, etc. Varies

Example of capital expenditure

None directly Renovation and expansion

Is itself a capital expenditure

Education and training


Direct cash inflows

Dividends and interest

None None Salary Pension income, etc.

Indirect cash inflows

Appreciation Appreciation None Employee benefits


* Excludes other assets, including private revenue generating real estate, which are difficult to generalize. † Generally included under human-related assets in this book. ‡ Stable for bonds. § Increases as the date that payoff begins draws closer and then declines after payoff begins.

TABLE 8.1 Characteristics of Household Assets*

2 Pension assets then are those that provide streams of income over time. Pension plans such as 401(k)s that allow the withdrawal of monies in lump sums are considered financial assets.

Chapter Eight Household Investments 201

significantly be subject to a measure of judgment. We discuss human assets here and deal with pension assets and gifts and bequests in the retirement and estate planning chapters, respectively. The third category, other assets, is a catchall. It comprises any other assets of worth. Some examples are jewelry, collectibles such as art or stamps, interest in a private business or other private investments, and prizes. A summary of characteristics for household assets is given in Table 8.1. Note that it uses a new category of marketability: fairly marketable. Items in this category can be sold but doing so involves one or more problems, which we can call inefficiencies. They can be transaction cost, time to find a buyer and close the sale, or time needed for the seller to substitute another asset for household use. External factors may impede marketability such as selling during an economic recession or having an unfashionable style or need for refur- bishment or repair by the buyer. Each of these inefficiencies can expose a person to higher cost or increased risk. Given this new category, the efficient marketable asset has been termed a fully marketable asset. In contrast to this more precise definition, in other uses throughout the book, the term marketable stands for fully marketable. A summary of household assets is given in Figure 8.1.


Decisions about which nonfinancial assets to select don’t come out of thin air. Instead, we form conclusions based on the values presented by investment alternatives. Our evaluation process for household investments begins by looking at the three ways household deci- sions are made and how total portfolio management relates to them. The process then describes capital expenditures and provides a step-by-step accounting for how decisions for many household assets should be determined. The final section describes the capital budgeting tools needed to measure the attractiveness of proposed investments.

Household Finance and Total Portfolio Management Household finance considers the household as one enterprise that resembles a business. Each of its operations can require investments. External work-related activities may require an investment in human assets such as an outlay for education; the house may re- quire a new roof or a new furnace; and future retirement needs may necessitate constant investments in financial assets.

Household Assets

Financial Nonfinancial

OtherStocks Bonds Mutual Funds

Exchange Traded Funds

Real Estate

Durable Goods

Human Related

Private Investments

Commodities and Gold

Jewelry and Collectibles


Appliances Auto Furniture InheritanceJob Pensions

Real Assets

FIGURE 8.1 Common Household Assets

202 Part Three Portfolio Management

Each of these investments can be evaluated from three perspectives:

1. Individual asset basis. Under the individual asset approach, decisions are made con- sidering the investment’s risk and return characteristics on a stand-alone basis. The question to answer is when looked at by itself, is this asset attractive?

2. Within activity basis. An investment can be proposed in any household activity. The question asked is how this proposed expenditure compares with current or future alter- natives within the same activity. For example, under human assets, considerations may be whether paying for education to improve skills in the current job or pursuing an MBA is more attractive. Sometimes the household thinks of investments in financial and nonfinancial assets as separate activities, comparing all alternatives within one of these two categories at the same time. For example, in financial investments, the ques- tion frequently asked is whether to sell selected bonds and buy additional stocks.

3. Fully integrated basis. Decisions are made not on a per asset or per activity basis but on an overall household basis. Each activity has assets that benefit the household. These assets can be grouped into financial and nonfinancial categories, as discussed. Together they form a portfolio of assets, the household portfolio. We can call the pro- cess of developing and maintaining an efficient combination of assets total portfolio management (TPM).

The nature of the household lends itself to centralized decision making. It generally has few adult members, thus permitting quick integrated decisions. The assets themselves are best assessed on a combined basis because resources are limited. Therefore, important goals are prioritized on an integrated household level. Moreover, tolerances for risk are set on an aggregate basis by household members. TPM looks at the household as a portfolio of assets.3 It presents solutions as to which assets should be placed in the household portfolio and how to weight them. The TPM ap- proach incorporates both risk and return. In more sophisticated versions, it incorporates correlations—that is, the degree to which individual assets are subject to the same risks. Generally, the lower the correlations, the lower the risk. By providing the appropriate blend of assets, TPM assists the household in operating efficiently. The household may engage in all three decision-making approaches. The purest ap- proach is evaluation through TPM. Even TPM, which is discussed in the next chapter, can be treated on a less comprehensive within activity basis because it typically considers fi- nancial assets alone.

Example 8.1 Sal and Diane, ages 31 and 30, are married and live in a rural town. The town was once a thriv- ing mining and manufacturing center but now has a disproportionate number of elderly. When children grew up, they moved elsewhere and few new people moved in. Consequently, the population declines modestly each year. Sal runs a lucrative minisupermarket that he inherited from his father. Diane is a clothing store manager in town who wants to become a lawyer. The couple are considering a number of investments. Each investment had passed an initial screening and was thought to be attractive on a stand-alone basis.

1. Purchasing a vacation home in the mountains nearby. 2. Adding a bedroom to their existing home for anticipated children to come. 3. Beginning to put away money in stocks and bonds for retirement. 4. Diane’s applying to a law school located one hour away. 5. Sal’s attending an expensive cooking school one weekend a month. The store could then

offer fresh-baked goods.

3 Liabilities are incorporated as negative assets here—terminology that has been used before. In other chapters, assets and liabilities are usually treated separately.

Chapter Eight Household Investments 203

They did some preliminary calculations and decided that they didn’t have enough resources for all these investments. Borrowing money would only provide limited help because they be- lieved anything more than $150,000 in loans would exceed their household tolerance for risk. One of the five proposals would have to go. The couple grouped their investment proposals into categories: real assets, financial assets, and human-related assets. They decided that both real asset proposals were important. The addition to the home was needed because they expected to have children soon. The vacation home was required to offset the long hours at the store and could be purchased at a below- market price. The investment in financial assets for retirement had to begin. They were already behind where they wanted to be for an early retirement. That left the two investments in human-related assets. On a within activity basis, these two proposed assets were believed to have the lowest returns of all the alternatives. Between the two, Diane’s attending law school would be more attractive than Sal’s cooking school potential. It would provide a higher return on human assets. They had conducted their final evaluation on a TPM basis, looking at all proposals at the same time. They thought they had completed their deliberations. However, when looking at the results on an overall household portfolio basis, they recognized a weakness. Household risk, even with the limitation on debt, would exceed their overall risk tolerance. Virtually all their real human-related and other assets where the supermarket was located were subject to the risk attached to (correlated with) a community suffering a population decline. Sal’s business, Diane’s job, and their home would all be negatively affected by a further drop in the town’s population. If the decline accelerated, all their nonfinancial assets could be seriously affected. They decided to substitute an equally attractive vacation home located near a large growing community. They would have to drive two hours to reach it, but it would materially reduce their dependence on their current community and therefore on overall TPM risk. Decision mak- ing was finally completed.

The balance of the chapter provides the method of selecting common household investments—those having to do with real assets and human-related assets. It will enable you to decide if you should accept or reject proposed expenditures, whether they be for a house, a car, or a master’s degree. It will detail whether to buy or lease a house or a car and how to decide on the amount you can spend for a home.

Making Capital Expenditure Decisions Capital expenditures are outlays that provide benefits over an extended period of time. These outlays improve household operations as soon as they become available. Capital expenditure is the term used for an outlay for real or human-related assets but not for financial ones. The capi- tal outlays can be used for purchasing new assets or improving existing ones. For a discussion of the theory for making capital expenditures, called capital budgeting theory, see Appendix I. An understanding of capital improvements may require consideration of how the tax code views repairs versus capital improvements. If Will and Beth Allen have a leak in their home’s roof, they have little or no choice but to repair it. To the IRS, this is an ordinary expense and provides no tax benefit for the Allens. However, Will and Beth also can make a decision to spend money on replacing their roof, using higher-quality materials designed to last for decades, rather than spending money elsewhere. The IRS likely will consider this roof replacement a capital improvement, which may ultimately provide tax savings when the home is sold. The Allens can weigh several factors in deciding whether the roof should be repaired (involving lower repair costs and less hassle with roofing contractors) or replaced, which might have possible tax benefits. The benefits of capital expenditure may be higher revenues, lower cash cost, or less time to produce a desired result. Alternatively, the benefit may involve just an immediate increase in satisfaction. We often have a variety of capital expenditure alternatives. We must decide which to fund from household cash flows and household assets and which

204 Part Three Portfolio Management

merit borrowing money. We should do so by using the established business capital budget- ing techniques of calculating net present value (NPV) and internal rate of return (IRR).4 Before we describe these techniques, let’s go over the capital budgeting process.

The Capital Expenditure Process The ideal process of selecting capital expenditures is the one presented next as a series of steps. In reality, adherence to this schedule depends in part on the type and cost of capital outlays. When the returns are measurable and the cost is high, this recommended proce- dure is more likely to be followed. For example, in considering the purchase of a fuel-efficient furnace, the process and quantitative measurement of returns are more likely to be followed than in the purchase of a new HDTV set for which satisfaction levels are difficult to measure. But even when measurement is difficult, alternatives generally can be ranked in order of attractiveness. Here are the steps.

Review Goals Households have not only desires but also needs. We can loosely categorize them as dis- cretionary and nondiscretionary outlays. For example, whereas we can consider the option of retirement without assets, in reality we need to save sometime before retirement or we risk working forever or sustaining a sharp drop in our standard of living during retirement. Our goals of future priorities can result in our having limited resources for spending, even capital spending, today. Thus, it is important to place our household investments in the context of our overall goals.

Establish Required Rate of Return The household’s capital outlays must reach a required rate of return for all projects. Its members must decide on that return based on market figures for savings and investing in financial assets and on their priorities. For example, if market returns on stocks with com- parable risk to the household’s capital project have historically been 10 percent over the long term, members use that percentage as their required rate of return.

Identify Potential Projects Households generally don’t have to look for projects—they are usually apparent. They should just be considered at the time evaluation is to begin.

Evaluate Projects Normally, households view the costs and returns for each project. When feasible, its mem- bers calculate returns using IRR or NPV, to be discussed in a later section.

Rank All Projects Here the household ranks all projects using stand-alone calculations—first on a within activity basis, then within the category, and finally on a total portfolio basis. Their risk and blending (correlations) with other assets are considered, particularly on the total portfolio basis.

Establish Overall Capital Availability Perhaps more so than for businesses, capital is limited for the household. Debt financing is available to some degree, but, of course, it raises risk. Considering all factors, the amount of capital to be made available is established.

4 As Copeland and Weston say, “The decision criterion for investment decisions which is to maximize the present value of lifetime consumption can be applied to any sector of the economy.” See Thomas Copeland and J. Fred Weston, Financial Theory and Corporate Policy, 3rd ed. (Reading, MA: Addison-Wesley, 1992), p. 17.

Chapter Eight Household Investments 205

Select and Invest in Final Projects Based on returns, capital availabilities, and risk and risk tolerance, the household decides on the assets it wants to fund. Some drop out forever; others are brought up at a future time when relative attractiveness and financial resources change.

Capital Budgeting Techniques The two most prominent capital budgeting techniques are NPV and IRR. Let’s discuss them separately.

Net Present Value (NPV) Chapter 2 introduced the time value of money concept. Both NPV and IRR are time value of money concepts applied to capital budgeting. The net present value (NPV) can be defined as the present value of all projected future cash inflows and outflows. It provides the amount of benefit from a capital expenditure as compared with investing the money in marketable investments. We receive the present value by discounting all cash flows back to the present at an appropriate discount rate.5 This discount rate is generally equal to the investment return—what could be earned on marketable securities with similar risk characteristics. We used the market rate because it is the minimum rate that must be earned on the capital expenditure. If we can’t earn that rate on capital expenditures, we probably should invest the money in marketable securities such as stocks and bonds. We can call this discount rate based on market factors the required rate of return.6 The NPV tells us whether we have earned the required rate of return. If NPV is zero or higher, we have earned it, and the capital expenditure is accepted. In other words, when NPV is positive, the capi- tal expenditure is preferable to a marketable investment. If NPV is negative, we have not earned the required return and reject the proposed expenditure. NPV is given by the following formula:

NPV = a n


CFt 11 + k2t − CF0


CF = Cash flow generated CF0 = Amount invested (often a cash outflow) at time zero, the beginning of the


k = Discount rate t = Time period involved n = Number of years

©nt=1 = Sum of the present values of cash flows from time 1 to time n

In sum,

NPV = Sum of future cash inflows

Discount rate − Cash outflow in current period

= Present value of future cash inflows − Cash outflow in current period

When the present value of future cash inflows exceeds the initial outflow, we consider accepting the capital expenditure. When the present value of future cash inflows is less than the initial cash outflow, we reject the capital expenditure.

5 Its definition, then, is the rate that we use to bring future cash flows to the present to establish their current value. 6 It can be defined as the return that must be earned to make an investment attractive. Market factors including the investment risk should be incorporated.

206 Part Three Portfolio Management

Example 8.2 A capital expenditure with a $1,000 initial cost and present value of inflows of $1,500 would have a $500 NPV and be accepted. If the initial cost was the same $1,000, but the inflows were only $900, the NPV would be negative $100, and the project would be rejected. In the negative $100 case, it is better to invest in marketable securities.

Example 8.3 June was thinking of purchasing a new air conditioner for her den. She had a home office there, and the air conditioner would be on 16 hours a day for 9 months of the year. The exist- ing air conditioner worked well but was not energy efficient. The new air conditioner would save about $15 a month in energy costs. It was of lower overall quality and, in fact, was expected to last only five years, about the useful life of the existing machine. June wondered whether the new machine’s energy efficiency would extend throughout its life span. Given the greater risk of this machine, June decided to assign a higher discount rate to it. This required rate of return would be 12 percent, about equal to marketable securities/common stocks with the same risk profile. The machine would cost $650. Using annual figures, calculate whether June should purchase the machine.

Initial cash payment = $650 Yearly cash inflows = $15 × 12 months

= $180 per year Number of years in inflows = 5

Required rate of return = 12%

Calculator Solution

General Calculator Approach Specific HP12C Specific TI BA II Plus

CF Clear the register f FIN 2nd CLR Work Enter initial cash outflow 650 CHS g CF0 650 +/− ENTER ↓ Enter cash inflows years 1−5 180 g CFj 180 ENTER ↓ Enter number of years 5 g Nj 5 ENTER ↓

Enter the discount rate 12 i NPV 12 ENTER ↓

Calculate the net present value f NPV CPT −1.14 −1.14

Calculator Solution

Step HP12C TI BA II Plus

Clear the register Press f FIN Press CF 2nd CLR Work

Enter initial outflow Enter cash flow in

CF0 register as CHS g CF0

Enter cash flow in CF0 register as −/+ Enter ↓

Enter succeeding

outflows or inflows

Enter cash flows in CFj register

successively as g CFj

Enter cash flows in C register successively

as Enter ↓

Enter number of years

for repeating cash flows

Enter number of years in Nj

register as g Nj

Enter number of years in F register as

Enter ↓

Enter the discount rate Enter the discount rate in i

register as i

Enter number by pressing NPV key in

the number Enter ↓

Solution Press f NPV Press CPT

The NPV is negative. The proposed capital expenditure should be rejected. June could do better by investing the contemplated $650 purchase price in marketable securities.

Chapter Eight Household Investments 207

If we had access to unlimited funds, we would accept all capital expenditures that would have a positive NPV. However, often our source of capital is limited. In that instance, we must select those investments that provide the highest returns.7 Unfortunately, NPV alone doesn’t provide that figure by comparing investments that differ in amounts invested. To rank investments in terms of attractiveness, we can use the profitability index (PI). It relates the amount of the NPV to the size of the original investment. The higher the value of the profitability index, the more attractive the investment is.

Profitability index = NPV

Original cost

Any savings in the opportunity cost of time should be included in calculating the additional cost or benefits for household expenditures. That is so because this time used potentially could be employed in developing additional cash flows. As discussed in Chapter 4, we as- sign a cash flow figure to the cost of time based on the hourly wage rate that could be re- ceived if the time was spent working.

Example 8.4 Jason is considering purchase of a new vacuum cleaner. He is interested in two electric models. Both models would save him a quarter of an hour of time a week. The lower-quality vacuum would last three years and would cost $300; the higher-quality model would last eight years and cost $400. The purchase of either model would be funded from existing savings. Jason earns $15 an hour after tax in his job. His required rate of return based on what he could earn in the market is 6 percent after tax. Should he make the investment? If so, which one should he buy? Express all figures on an annual basis.

Lower-Quality Machine

Initial outflow = −$300 Weekly inflows = Savings in time × Hourly wage

= 1/4 hour × $15 = $3.75

Yearly inflows = $3.75 × 52 weeks = $195

7 Actually, the selection process under restricted borrowing would have to be made incorporating decision making over a multiyear basis. See Neil Seitz and Mitch Ellison, Capital Budgeting and Long-Term Financing Decisions, 3rd ed. (Fort Worth, TX: Dryden Press, 1999), pp. 722–725. See also Simon Gervais, “Behavioral Finance: Capital Budgeting and Other Investment Decisions,” in Behavioral Finance: Investors, Corporations, and Markets, ed H. Kent Baker and John R. Nofsinger (2010) for behavioral aspects of capital budgeting; faculty.fuqua.duke.edu/~sgervais/Research/Papers/BookChapter.OvCapitalBudgeting.pdf.

Calculator Solution

General Calculator Approach Specific HP12C Specific TI BA II Plus

CF Clear the register f FIN 2nd CLR Work Enter initial cash outflow 300 CHS g CFo 300 +/− ENTER ↓ Enter cash inflows years 1–3 195 g CFj 195 ENTER ↓

Enter number of years 3 g Nj 3 ENTER ↓

Enter the discount rate 6 i NPV 6 ENTER ↓

Calculate the net present value f NPV CPT 221.24 221.24

208 Part Three Portfolio Management

Higher-Quality Machine

Initial outflows = $400 Yearly inflows = $195, as above

Profitability Index

Lower-quality machine = 221.24


= 0.74

Higher-quality machine = 810.91


= 2.03

Both investments have positive NPVs, but the higher-quality machine has a higher profitability index and is, therefore, the more attractive investment.

Internal Rate of Return (IRR) The internal rate of return (IRR), which we discussed briefly in Chapter 2, provides a return on investment as a percentage. It can be defined as the rate of return that makes the present value of cash inflows equal to that of cash outflows. The IRR is, therefore, the discount rate that makes NPV equal to zero. The IRR approach is very similar to obtaining an NPV with cash inflows and cash outflows calculated. However, instead of inputting a market-based discount rate, we solve for the IRR. We compare the IRR with our required rate of return, the return we could get on marketable securities with the same risk. If the IRR is higher than the required rate of return, we accept it. If it isn’t, we reject the proposed capital outlay.

Calculator Solution

Step HP12C TI BA II Plus

Clear the register Press f FIN Press CF 2nd CLR Work Enter initial outflow Enter cash flow in CF0 register as CHS g CF0

Enter cash flow in CF0 register as −/+ Enter ↓

Enter succeeding outflows or inflows

Enter cash flows in CFj register successively as g CFj

Enter cash flows in C register successively as Enter ↓

Enter number of years for repeating cash flows

Enter number of years in Nj register as g Nj

Enter number of years in F register as Enter ↓

Solution Press f IRR Press IRR CPT

Example 8.5 Brandt is considering purchasing a new personal computer and related software that would cost $4,500. He has a part-time job editing books at home. He receives a flat fee per book that averages about $25 an hour after tax for 15 hours per week, 50 weeks a year. He expects to maintain this job for three years until his regular career pays enough money, at which point he

Calculator Solution

General Calculator Approach Specific HP12C Specific TI BA II Plus

CF Clear the register f FIN 2nd CRL Work Enter initial cash outflow 400 CHS g CFo 400 +/− ENTER ↓ Enter cash inflows years 1–8 195 g CFj 195 ENTER ↓

Enter number of years 8 g Nj 8 ENTER ↓

Enter the discount rate 6 i NPV 6 ENTER ↓ Calculate the net present value f NPV CPT 810.91 810.91

Chapter Eight Household Investments 209

would stop editing. He believes the new setup would increase his output by 10 percent. Assuming that his after-tax required rate of return is 11 percent, use annual savings calcula- tions to determine whether he should purchase the computer.

Initial payment = $4,500 Weekly inflows = Existing hourly wage × Hours per week

= $25 × 15 hours = $375

Yearly inflows existing = $375 × 50 = $18,750

Increase in yearly inflows = 10% Yearly inflows proposed = 18,750 × 1.10

= 20,625 Yearly benefit = 20,625 − 18,750

= 1,875 Years benefit applicable for = 3

Calculator Solution

General Calculator Approach HP12C TI BA II Plus

CF Clear the register f FIN 2nd CLR Work Enter initial cash outflow 4,500 CHS g CFo 4,500 +/− ENTER ↓ Enter cash inflows years 1–3 1,875 g CFj 1,875 ENTER ↓

Enter number of years 3 g Nj 3 ENTER ↓

Calculate the internal rate of return f IRR IRR CPT

12% 12%

The IRR of 12 percent exceeds the required 11 percent. Therefore, the capital expenditure should be made.

Comparison of IRR and NPV Methods In evaluating these two approaches, NPV is the purer, more accurate method. However, because IRR is expressed in terms of percentage of return, it can be easier to understand. Moreover, an IRR can compare returns for expenditures of different amounts and time frames. A major difference in approach is that NPV assumes that cash flows from projects are invested at the required rate of return whereas IRR assumes that they are reinvested at the rate of return of that particular project. The weakness in the IRR approach is shown in Example 8.6. IRR also gives multiple answers under some circumstances.

Example 8.6 Suppose we were able to set up our first hamburger fast-food restaurant next to the sports center in our town with an inexpensive long-term lease. We planned to build other restaurants in the chain that would have an expected rate of return of 15 percent. We would probably have a very high IRR, say 90 percent a year, because of our location. Clearly, cash flows from that hamburger capital expenditure used to build other restaurants would probably not earn the same rate of return as our original investment. Thus, the NPV method, which employs the required rate of return of 15 percent for reinvestment, is more accurate than the IRR, whose ap- proach would assume a 90 percent return on the cash flows generated for the new restaurants.

There are ways to adjust for the reinvestment effect and other weaknesses of IRR. In most cases, both methods provide the same ranking of alternative expenditures.

210 Part Three Portfolio Management


We know that households engage in production activities just as businesses do. They pro- duce goods and services for internal household use and for external market-related activi- ties. Capital expenditures can make each individual good or service more productive. Consequently, the household makes many types of capital expenditures. Selected ones were presented as examples illustrating NPV and IRR techniques. In this section, we concentrate on decision making for what is often the three largest capital expenditures a household has: the car, the person, and in summary form the home. All three are thought of as investments in contrast to other outflows, which are expenses. That is so because they provide benefits that extend beyond the current period. We look at them separately beginning with durable goods and the car.

Durable Goods Purchases of consumer durable goods are capital expenditures that can benefit many types of household operations. Whether for a job, a nondiscretionary activity, or a discretionary activity, they provide returns to the household over an extended period of time. Among the reasons for purchasing a durable good are these:

1. To take advantage of a technological improvement with the potential to make house- hold maintenance more time efficient. For example, a new dishwasher can free time to be used to generate additional work-related income or to further leisure pursuits.

2. To replace an existing durable that has reached the end of its useful life because of physical wear and tear.

3. To reflect a change in circumstances; for example, a rise in the price of oil can sub- stantially change the cost and therefore the economics of a “gas-guzzling” automobile. The result may be the purchase of a fuel-efficient car.

4. To provide more pleasure—for example, purchasing a home theater system with sur- round-sound speakers.8

5. To attempt to raise returns on assets—for example, buying an investment software package with the hope of increasing investment performance.

The Automobile Because the car is generally the most expensive, pure consumer durable the household purchases, let’s use it as a practical example. Like most other durables, a car declines in value over time. This capital expenditure can assist in transportation to work, make household necessi- ties easier to obtain, and provide pleasure in itself or through its ability to take us to other pleasurable activities. Most multiperson households have at least one car. Depending on operating patterns, they may exchange cars as often as once a year or as infrequently as once in, say, 10 years when, for practical purposes, the car may no longer be considered useful. The car may be purchased for cash or debt, or it may be leased. A lease-versus- purchase example is given in Appendix IV. Some of the major factors in deciding to change automobiles, whether for a new or used car, are

8 To understand how capital expenditures on leisure products may be valued, see Appendix II, Assumed Rents.

Factor Explanation

State of current car The higher the repair bills, the lower the car’s attractiveness, and the more likely a trade-in will be contemplated.

Chapter Eight Household Investments 211

Factor Explanation

Existing finances The greater the cash on hand, the more favorable the job and economic outlook, the more likely the trade-in.

Current car promotions At certain times in the economic cycle, the purchase of a new or used car may be particularly attractive. This means that prices, leases, and financing terms may cause households to exchange cars prior to their intended date.

Attractiveness of new car New cars may have style, safety, or mileage features that motivate peo- ple to buy them.

The factors that enter into a decision to purchase one car over another include its cost, its quality that would lead to lower repair bills, its fuel efficiency, safety features, its ride and cabin comfort, its projected trade-in value, and its style and image.

Example 8.7 Natasha has a suburban home within walking distance of the railroad. She commutes to work in the city at a cost of $180 a month. She also rents a car every weekend, which costs $600 a month including insurance and fuel. She is considering purchasing a new car for cash to replace commut- ing and rental costs. It would cost $25,000, get 28 miles per gallon, and have an estimated resale value of $10,000 after five years. After buying this car, Natasha would drive 15,000 miles per year and have maintenance and repairs of $2,000 per year, insurance of $1,500 per year, and fuel costs of $3 per gallon. Assume that all costs occur at the end of the year and that she sells the car at the end of the fifth year. If Natasha’s discount rate is 6 percent after tax, should she purchase the car?

Annual Operating Cost of Car

Yearly Maintenance Cost

Fuel consumption a15,000 miles 28 mpg

b = 535.7 gallons per year

Fuel cost 1535 gallons × $32 = $1,607.14 Annual repairs and maintenance = $2,000

Annual insurance = $1,500 Total projected yearly cost = $5,107

Current Annual Cost Commute 1$180 × 122 = $2,160 Car rental 1$600 × 122 = $7,200

Total current annual cost = $9,360 Annual savings = 1$9,360 − $5,1072 = $4,253

Cost to purchase car = $25,000 Selling price year 5 = $10,000

Calculator Solution

General Calculator Approach HP12C TI BA II Plus


Clear the register f FIN 2nd CLR Work

Enter initial cash outflow 25,000 CHS g CFo 25,000 +/− ENTER ↓

Enter cash inflows years 1–4 4,253 g CFj 4,253 ENTER ↓

Enter number of years 5 g Nj 5 ENTER ↓

Enter cash inflow year 5 14,253 g CFj 14,253 ENTER ↓ ↓

Calculate the internal rate of return f IRR IRR CPT

6.47% 6.47%

The return for this capital expenditure is 6.47% percent. It significantly exceeds the required 6 percent rate, so the car should be purchased.

212 Part Three Portfolio Management

Human Assets Our human assets are the human capital we have that we and others value: knowledge, skills, intellectual capacity, strength, beauty, compassion, ethical behavior, creativity, drive, health, and so on. From a financial standpoint, we often limit ourselves to factors that directly enter into our income-earning ability. Often, these factors are simplified to two basic traits: knowledge and skills with general health used as support for them. We can now define human assets as the resource that reflects the current value of all our future earnings. It is a nonmarketable asset; that is, it cannot be sold. Instead, it is often rented to an employer for a period of time at an hourly fee or a salary. Without knowledge and skills, human capital can be viewed as a basic commodity with the ability to earn only the minimum wage. Capital expenditures in this area include time and money spent on for- mal education and other ways to develop knowledge, many through practical experience. In effect, education, training, and proper health habits can provide us a higher return on our life cycle human assets. Empirical evidence points to often attractive returns of 14 to 16 percent on human assets9 although returns on human capital may vary among segments of society as well as between men and women.10

Capital expenditures to raise human assets are not restricted to job-related activities. They can be made in all relevant areas of the household. You may take a course to make

Consideration of household assets generally over- looks human assets. For example, the household’s balance sheet normally doesn’t contain a calculation of human assets. That is true despite the fact that human capital is often the household’s largest asset by far. The lack of attention given to human assets ex- tends to capital expenditures. The recognition of money spent for multiyear benefit is often restricted to durable goods. We can see or touch new durable goods. They are the household’s equivalent of busi- ness equipment. Perhaps overlooking capital outlays on humans occurs because human beings can be seen, but the capital expenditures on such qualities as knowledge are intangible—such assets cannot be seen or touched. Nonetheless, most people would agree that education can add to long-term

income-earning capacity and therefore qualifies as a capital expenditure. For example, most people wouldn’t be spending the money and time pursuing business-oriented education—including the study of this textbook—if it weren’t for the potential impact on their income. Personal financial planners are aware of how important human assets are in their work for clients. Although they don’t normally place human assets on the balance sheet, they incorporate them in capital budgeting decisions and, of course, include them in projections of salaries in the cash flow statement. They recognize the relevance of capital expenditures on education and the capacity to earn additional income. In other words, planners recognize that cap- ital expenditures can incorporate human assets as well as durable goods.

Practical Comment The Importance of Human Assets

9 Gary Becker, Human Capital: A Theoretical and Empirical Analysis with Special Reference to Education, 3rd ed. (Chicago: University of Chicago Press, 1993). See also Adam Looney and Michael Greenstone, “Regardless of the Cost, College Still Matters,” The Hamilton Project, 2012, hamiltonproject.org/papers/ Regardless_of_the_Cost_College_Still_Matters/. Looney is Senior Fellow, The Brookings Institution, and Greenstone is 3M Professor of Environmental Economics, MIT. 10 See, for example, F. Blau, M. Ferber, and A. Winkler, The Economics of Women, Men and Work, 4th ed. (Upper Saddle River, NJ: Prentice Hall, 2001); also Mark M. Pitt, Mark R. Rosenzweig, and Nazmul Hassan, “Human Capital Investment and the Gender Division of Labor in a Brawn-Based Economy” (American Economic Association, 2010), aeaweb.org/aea/2011conference/program/retrieve. php?pdfid=112

Chapter Eight Household Investments 213

you a better investor. You may read Consumer Reports each month to develop some ex- pertise in purchasing useful household appliances and obtain help in deciding which brand to buy. You may purchase a book on how to cook quickly but effectively. Finally, retired people may attend seminars on how to better enjoy retirement life.

Calculating Human Assets The value of our human assets varies over our life cycle. If we are skilled employees, our asset value may actually go up for a time.11 However, as we age, the decline in the number of our earning years generally results in a drop in our human assets over our life cycle. In effect, like many other assets, human assets depreciate over time. Capital expenditures on human assets are treated similarly to those for other assets with benefits compared with costs. Consider Example 8.8.

Example 8.8 Astrid, age 30, is a married architect with one child. Her salary has reached a plateau at $75,000 a year. She believes that if she pursues an MBA degree full-time, she would move into a mana- gerial position and her salary would rise by $45,000 a year. Astrid wants to maintain her current lifestyle, which already generates substantial yearly cash savings and accumulate the capital to leave to her son. Her MBA course would take two years to complete and cost $48,000 a year. Because she plans to pay for the MBA out of existing savings and would be spending the money to qualify for a new position, she would not be eligible for any tax benefits. Assume that Astrid pays one-third of her salary in taxes and her tax bracket will remain unchanged after the raise, that she can earn 6 percent after taxes on investments with a similar risk to her job, and that she plans to retire at age 65. Furthermore, assume that all salary and schooling payments are made in a lump sum at the beginning of each year. What is her rate of return on this investment? Should she pursue an MBA? If so, what will be the value of her hu- man capital, assuming a calculation that incorporates salary forgone and her extra salary from obtaining her MBA upon graduation. Her after-tax increase in salary per year is

After-tax gain = Pretax gain × 11 − t2 = $45,000 × 11 − 0.33332 = $30,000 per year

Numbers of years of gain = Retirement age − 1Current age + Full-time MBA study2 = 65 − 130 + 22 = 33 years

The cost of attending school is

Schooling cost = $48,000 a year for 2 years Opportunity cost of time = 2 years of salary forgone

= $75000 × 11 − t2 = $75000 × 11 − 0.332 = $50,000 a year for 2 years

Combined yearly cost = Schooling cost + Opportunity cost = $48,000 + $50,000 = $98,000 a year for 2 years

11 That is because of the higher present value of higher-earning years as we draw closer to them. For a time, higher earning years can more than offset the effect of fewer work years.

214 Part Three Portfolio Management

Internal rate of return = 14.1 percent

Because that rate exceeds Astrid’s rate of return on marketable investments of 6 percent, she should pursue the MBA. The value of her human capital would be

New salary = $75,000 + $45,000 = $120,000

After-tax income = $120,000 × 11 − 0.33332 = $80,000

Calculator Solution

General Calculator Approach HP12C TI BA II Plus

Clear the register f FIN 2nd CLR Work


Enter cash outflow year 1 98,000 CHS g CFo 98,000 +/− ENTER ↓ Enter cash outflow year 2 98,000 CHS g CFj 98,000 +/− ENTER ↓ ↓ Enter cash inflows 30,000 g CFj 30,000 ENTER ↓

Enter number of years 33 g Nj 33 ENTER ↓

Calculate the internal rate of return f IRR IRR CPT

14.1% 14.1%

Value of human capital = $883,527

The Home The home is the household’s most important tangible asset. It has many functions. By put- ting a “roof over your head” it is a durable good, which belongs in this chapter on house- hold assets. However, its ability to rise in value over time also makes it an investment asset along with other real estate. We have chosen to present it in the next chapter, Chapter 9 on real estate and other assets.

Behavioral Realities In general, the structure identified for capital budgeting decisions in this chapter represents an ideal framework. In reality, many such decisions are made using mental shortcuts. The portfolio approach to capital expenditures in a one-person household can be just the mental

Calculator Solution

Enter cash outflow year 1 98,000 CHS g CFo 98,000 +/− ENTER ↓ Enter cash outflow year 2 98,000 CHS g CFj 98,000 +/− ENTER ↓ ↓ Enter cash inflows 80,000 g CFj 80,000 ENTER ↓

Enter number of years 33 g Nj 33 ENTER ↓

General Calculator Approach HP12C TI BA II Plus

Clear the register f FIN 2nd CLR Work CF

Enter the discount rate 6 i




Calculate the net present value f NPV CPT

883,527 883,527

Chapter Eight Household Investments 215

consideration of how this proposed asset affects cash flow, overall assets, and debt. In a two-person household with specialization of tasks, some less significant decisions are made on an individual asset, stand-alone basis. However, important decisions for all households are generally made or approved on an overall portfolio basis. And last, as mentioned in Chapter 5, household members and financial advisors alike sometimes forget to place significant capital expenditures into cash flow forecasts. Thus, they may omit such items as household remodeling and replacement of automobiles. In either case, average amounts should be placed in yearly or lump-sum amounts assumed over appropriate time periods, adjusted for inflation. Without anticipating such items, sav- ings needs can be materially understated.


Leasing often represents the alternative to making an investment in a nonfinancial asset. In many cases when the asset is essential such as with a car or home, we can perform a buy versus lease analysis to determine which approach to take. In this sec- tion, we examine the strengths and weaknesses of leasing and evaluate choice for a car or home. We provide an appraisal of the home as an investment using the lease as a benchmark.

An Introduction to Leasing As stated, the investment values for capital expenditures such as durable goods usually decline over time. We tend to purchase them for their benefits for household activities today and for periods in the immediate future. Consequently, our principal purpose is to reap the benefits from the items because owning them does not result in their appreciation as, say, owning stocks would. Therefore, we are often open to considering leasing assets. A lease is a way to acquire the use of an asset without purchasing it. The lease allows you to receive the asset’s operating benefits, generally for a stated period of time, in return for an obligation to make a series of payments over the term of the lease. The maintenance and overhead costs may be paid by the lessor, the company providing the equipment. For

The degree to which households use financial analy- sis in making decisions on capital expenditures varies. When the expenditure is substantial and the benefits can easily be measured, households often make more efforts to include a cost-benefit analysis. For example, a household considering putting in a new, more efficient furnace to save fuel costs may compare its cost with the projected annual fuel sav- ings. They also may consider the anticipated useful life of the new furnace and the remaining life of the old one. They may do financial analysis exclusively or base the decision on information supplied by the furnace manufacturer or others.

The decision to buy a new pair of skis may be made more intuitively. The household members an- ticipate the extra pleasure they will have from using the skis and compare it with their cost. To improve the process, the financial aspects of the transaction should be emphasized. Whenever possible, the costs and benefits should be identified. When the item is purchased for its increase in leisure satisfaction and is difficult to quantify, a ranking system of proposed uses for the money can help identify its contribution to the household. In such cases, the effect of the outlay on the desired level of savings should be in- corporated in the decision-making process.

Practical Comment Use of Capital Budgeting Techniques

216 Part Three Portfolio Management

example, in an auto lease most costs are borne by the person using the vehicle, called the lessee, in a transaction known as a net lease.12,13

Reasons for Leasing There are economic reasons for leasing. A person might want to lease an expensive computer if he or she thought a better one might be introduced soon. The lessor may absorb the risk of tech- nological or fashion obsolescence or large unforeseen expenditures on the asset. Moreover, the lessor is sometimes able to develop efficiencies in specializing in that asset. For example, the purchase price of the asset and its repairs may be less costly to the lessor who buys, say, com- puters in volume. Finally, the business owner may receive tax benefits that the lessor will not.14

Nonetheless, the cost of leasing generally is higher than the cost of purchasing, includ- ing the cost of borrowing money to do so. And perhaps, most important, it is higher because another cost structure is included: the lessor’s administrative cost including the need for profit. It can, however, be the most profitable way to obtain use of an asset when it is needed for only part of the period. For example, it may be less costly to lease a car or house for a month in the summer than it is to own and maintain it all year. Probably the most common reason for leasing an asset is that households are short of capital. Leases may be offered with no down payment. For example, we’ve mentioned that, for people in significant marginal tax brackets, buying a house carries substantial built-in tax benefits, but for people who don’t have sufficient funds to purchase their own house, long-term renting is an option. Finally, leasing is generally not presented as a liabil- ity on the household’s balance sheet as it often is on the business’s balance sheet. Therefore, when the household is short of funds and has limited ability to borrow, leasing may not be a negative factor in qualifying for a new loan.

Automobile Leasing Today one out of four cars is leased. Consumers are attracted to the ability to drive a desir- able car with little or no down payment. Moreover, the cost of leasing has become more competitive with purchase; automobile companies have placed more emphasis on it and sometimes offer disguised subsidies to lessees in order to sell more cars. Whether it is preferable to lease or purchase a car depends on such factors as these:

• How long the car is to be held. Depreciation in prices of a car moderates after the first few years, which strongly favors its purchase if the purchaser plans to hold it for more than three or four years.

• The age of the car. New cars offer fewer problems and are covered by warranty. Leasing an older used car, when available, can subject the lessee to significant extra costs.

• The cost of time. Selling a car that is currently owned involves time and can expose the seller to price risk at the end of the designated ownership period. A lease that involves only dropping off the car at the end of its term can be drawn up quickly.

12 In theory, given a riskless environment with perfect capital markets, there should be no difference be- tween buying an asset and leasing it. The cost of the leasing payment would include a return to the lessor for purchasing it. The depreciation in its value over time and maintenance expenses, if there are any, would be borne by the lessor. The lessee’s cost would be equal to the lessor’s costs and would include the costs for maintaining the item over the term of the lease. A charge equal to the opportunity cost of capital also would be included because the capital not used to purchase the equipment could be invested elsewhere. 13 There are two basic types of leases: closed-end and open-end leases (see Chapter 7). In a closed-end lease (the most common for consumer vehicle leases), the lessee does not have an obligation to purchase the leased asset at the end of the agreement. On the other hand, with an open-end lease (rare for con- sumer leases, so care is warranted), also called a finance lease, the lessee has the obligation to pay the difference between a “residual value” and the “actual value,” if the latter is lower when the lease ends. 14 By providing flat lease payments, the lessor also takes the risk of higher interest rates. In contrast, the purchase of an asset financed in part through adjustable-rate debt exposes the buyer to higher interest costs should market rates rise.

Chapter Eight Household Investments 217

• Inspection standards. Lessees must comply with the lessor’s inspection standards in returning the car or face the consequences. What might be an almost unobservable scratch to the lessee or the person who purchases a car from her or him can sometimes require an expensive repair to bring the vehicle up to the lessor’s inspection standards.

• Mileage charges. Leases contain maximum mileage charges. Lessees who exceed the limit, can owe extra mileage charges. Lessees who are well under the limit, receive no benefit but are, in effect, being charged for mileage that they didn’t use.

• Lease obligation. A lease is made for a fixed period of time and may be difficult or expensive to break or find someone else to assume if the lessee experiences a change in circumstances. Assumption of the lease by a third party also could expose the lessee to liability in the event the sublessee defaults in payments. However, owners who can sell their cars may be affected by the cost of time factor.

• Ability to fund monthly payments. For those who have cash flow concerns, monthly payments for leasing will be lower than loan payments. On the other hand, once all loan payments have been made, those people own the car.

On balance, in the absence of manufacturer subsidies, leasing an automobile generally costs more than purchasing it outright. However, the extra cost for leasing may be accept- able to many, particularly those who hold new cars for around three years. The disparity in cost can be smaller in that period and more than offset by the absence of effort in changing cars and the benefit of having a risk-free sale of the relinquished car. Appendix III offers a description of the factors that enter into a lease. It also provides the computation of an actual lease payment. Table 8.2 provides a summary and description of the types of capital expenditures for the household.

TABLE 8.2 Analysis of Capital Expenditures

Type of Capital Expenditure Category

Summary of Capital Expenditures

Specific Cost or Activity

Examples of Activity or Durable Goods Specific

Capital Expenditure

Durable Goods Nondiscretionary Household overhead Mortgage interest, rent, fuel, electricity

Furnace, furniture

Nondiscretionary Household work Cooking, cleaning, child care, shopping

Dishwasher, oven

Nondiscretionary Biological Maintenance

Food, clothing, sleep


Discretionary Active Sports, traveling Ski, golf clubs Discretionary Passive Watching television Television, stereo Revenue related Human revenues Work Automobile as

transportation Revenue related Marketable assets Investing Computer

Human Assets: Education

Nondiscretionary All Any Books and seminars on improving productivity

Discretionary All Any Books and seminars on increasing pleasure

Revenue related Human revenues Work College, graduate school, conferences

Revenue related Marketable assets Investing Conferences Real Estate: Home

Nondiscretionary Household overhead See Durable Goods above

See Durable Goods above

Discretionary Active or passive Exercising, watching television

Construction of a den-exercise room

Revenue-related Real assets Investing Purchase of a home

218 Part Three Portfolio Management

College Age • Your biggest asset is you, so invest in learning and good grades.

• Analyze and experience possible careers through internships.

• Prepare for capital expenditures such as an apartment and durables when you graduate and hone social skills useful in jobs.

• Just working hard isn’t enough; feel free to do community service and go out with friends.

• For investment purposes, think beyond financial assets such as stocks and bonds. You have a portfolio of nonfinancial assets to add to financial ones.

Twenties • If you are earning decent money, buy some quality furnishings and an affordable car.

• You should emphasize making progress at work.

• Think about whether a part- or full-time Master’s program makes sense.

• Buy a good sound system to help relieve your tension.

Thirties • For many people, marriage and children can be excellent capital expenditures.

• Review your career. Determine whether you are making good progress. If not, re-evaluate.

• Think again about investing in a Master’s degree; it may be the last feasible time to get it.

• Invest in a home.

Forties • Prepare for children’s college costs.

• Make sure you have a car that fits your lifestyle.

• Keeping up to date on changes in your occupation is a necessity; it can pay dividends.

• Think about a midcareer change if you have come up short.

Fifties • Don’t fret too much about children’s college payments; for many your major financial obli- gations there should almost be over.

• During this age bracket, things are often easier financially, consider a calculated step up in living costs.

• Invest in yourself through enjoyable leisure activities—it can pay off all around. • Invest in changes in your home and its possessions.

Sixties • Prepare for retirement.

• Is there a part-time job that will fit in for a time?

• Keep up with your former career to help you stay mentally alert.

• Think of community service as a nonpaying job that can help you remain vital.

Seventies and Beyond • Congratulations, you are finally retired.

• Still think of the household as a business.

• If there is something you want to do this is the time to do it.

Life Cycle Planning Household Investments

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Chapter Eight Household Investments 219

Back to Dan and Laura HOUSEHOLD INVESTMENTS—CAPITAL EXPENDITURES I had already briefed Dan and Laura on nonfinancial investments and how they can im- pact their lives. I had asked them to make a list of the future investments they felt were important. Both Dan and Laura had come with one big item on their list. Dan felt he had to have a “status car.” That car would cost him $30,000 net of the trade- in value of his old car that he drove to the station. His insurance would go up by $800 a year, his fuel by $750 per year, and his maintenance cost by about $1,000 per year. However, he would save train costs of $1,000 per year and would be able to use the car for seven years, at which time he believed it would have little value. Dan planned to buy the car at the end of the year in December. He wanted to know whether this was a worthwhile investment. Laura was concerned about her family and her career. Many of her friends had gone back to work almost immediately after giving birth. She liked her work and believed that, as an elementary school teacher, she had a significant positive impact on the lives of many children. Moreover, she couldn’t see herself being content by staying home all the time. On the other hand, she thought it might be best for the children if she raised them in their early formative years. She said she might enjoy that period herself. I sensed that she was conflicted and asked her if my thought was correct. She nodded yes. I also had the feeling that, all other things be- ing equal, she wanted to stay home and raise her children until they began school. When I asked her that question, she agreed but wanted to know the financial implications of doing so. Laura mentioned she had thought of pursuing a master’s degree in teaching methodology with a specialty in reading. She believed that all the course work would help improve her performance in the classroom. She would begin in about a year, take the courses gradually while raising her children and have it completed in about five years. The cost would be $80,000 in current dollars spread equally over the four-year period with education costs ris- ing by 6 percent a year. Upon completion of her degree, she would be entitled to an $18,000 annual increase in salary. She asked me if I thought doing that made sense financially. I thought to myself that the three areas we would have to work on were a new car, when to go back to work, and whether to enroll in a master’s curriculum.

Here’s the advice I presented to them: We’ve discussed whether to purchase a new car (durable goods assets), when to go back to work, and whether to enroll in a master’s program (human-related assets); all lend them- selves to financial analysis. Let’s go over the car first. The purchase of the car is simple. You would have a one-time cost of $30,000 net of trade-in plus extra yearly expenses of $1,550. The benefit at the $50-per-hour rate for your time as- sumed conservatively not to rise each year would be $50 per day, $250 per week, $12,500 per year before taxes and $8,906 after taxes. Unfortunately, this automobile expense is not tax de- ductible. Your net inflows, therefore, are $7,356 per year. The return on this investment is very high at 19 percent. You should buy the car and start working extra hours as soon as it is feasible.

New Car


Cost of new car $30,000 Additional expenses $1,550 Additional work hours/week $5 Hourly rate $50 Marginal tax rate 28.8% After-tax hourly rate $35.63 Sale price $8,000


220 Part Three Portfolio Management

Laura, you would be making $50,000 a year if you were working today. At an assumed marginal tax bracket of 28.8 percent when you work, plus Social Security payments of 7.65 percent, that would leave you with about $33,000 per year after tax. You mentioned that a full-time housekeeper would cost $25,000 a year and transportation, clothing, and eating out another $2,000 a year. The difference of $6,000 per year is not very meaningful, particularly given your wish to raise your children yourself. The master’s program provides the potential to earn an $18,000 raise its completion with $80,000 in costs over four years. Assuming that your marginal tax bracket is 28.8 percent, federal and state, when you return to work, your benefit is a raise of about $12,800 per year in today’s after-tax dollars for 16 years to your intended retirement at 55.

Master’s Program


Cost of program $80,000 Inflation (college) 6.0% Pay raise upon completion $18,000 Marginal tax rate 28.8% After-tax pay raise $12,825 Years of employment 16 General inflation 3.0%

Inflows Outflows Net Cash Flow

2015 0 0 0 2016 0 ($22,472) ($22,472) 2017 0 (23,820) (23,820) 2018 0 (25,250) (25,250) 2019 0 (26,765) (26,765) 2020 $15,314 0 15,314 2021 15,773 0 15,773 2022 16,246 0 16,246 2023 16,734 0 16,734 2024 17,236 0 17,236 2025 17,753 0 17,753 2026 18,285 0 18,285 2027 18,834 0 18,834 2028 19,399 0 19,399 2029 19,981 0 19,981 2030 20,580 0 20,580 2031 21,198 0 21,198 2032 21,834 0 21,934 2033 22,489 0 22,489 2034 23,163 0 23,163 IRR 13%

2015 2016 2017 2018 2019 2020 2021 2022

Cash Flow

Inflows $8,906 $8,906 $8,906 $8,906 $8,906 $8,906 $16,906 Outflows ($30,000) $1,550 $1,550 $1,550 $1,550 $1,550 $1,550 ($1,550) Net cash flow ($30,000) $7,356 $7,356 $7,356 $7,356 $7,356 $7,356 $15,356 IRR 19%

As you can see, on your worksheet, the return on the graduate degree is high at 13  percent even without the additional pension benefits you would receive and the potential to receive


Chapter Eight Household Investments 221

an even higher return should you decide to retire later. Because it better fits your personal goals and provides an excellent return on investment, I believe obtaining the master’s de- gree to be a highly attractive investment. In sum, all of the proposed capital expenditures with the exception of going back to work immediately are considerably higher than those for investments in the marketplace with comparable risk, and therefore we recommend that you make them.

College Student Case Study and Review: Amy and John HOUSEHOLD INVESTMENTS Amy and her stepbrother John were both skeptical. They wanted to know what nonfinan- cial investments were and why these types of investments were important. I explained that the household has many types of assets besides financial ones such as stocks and bonds. The principle nonfinancial assets are real estate, other tangible assets—sometimes called durable goods—and human-related assets. Nonfinancial assets are important because they contribute to the functioning of the household, which can be called household production.15 They include pleasurable leisure as well as work-related activities. We study them because capital expenditures (outlays that provide long-term benefits) on nonfinancial assets can make the household more efficient, just as business capital expenditures can make business more productive. The intended outcome for businesses is higher profits whereas the outcome for households can be in- creased available cash flow, which raises household members’ standard of living. I thought Amy and John seemed a little puzzled, so I continued. Before we begin to describe household investments, it’s useful to know that the household enterprise* we just described evaluates such investments for purposes of making selections in three ways:

1. Individual asset basis. Looking at each option by itself.

2. Within activity basis. Making selections by comparing alternatives within type of assets. An example is deciding whether to spend available cash or credit to get a washing ma- chine or a dishwasher.

3. Fully integrated basis. Comparing all alternatives available.

Total portfolio management (TPM) compares all assets as is done in the third type of selection on a fully integrated basis and with the goal of obtaining the most efficient com- bination for the household. As mentioned, capital expenditures provide benefits over an extended period of time. The process of deciding on capital expenditures to make for household investments is similar to that used by a business. We review goals, establish our required rate of return, identify potential prospects, rank all projects, and establish how much money we have available to spend. We then select the number of items that meet our criteria up to the amount we have budgeted based on a rank order of attractiveness. We may use either the net present value (NPV) or the internal rate of return (IRR) method. NPV is more accurate whereas IRR is easier to understand because it is expressed in a return figure. Generally, the methods give the same result for deciding among alternative expenditures. Consider durable goods such as air conditioners, cars, televisions, and so on. We buy new ones when the old ones wear out, or if technological developments make new ones more appealing. The car is often the most expensive durable good. It is important to note that most durables decline in value over time.

15 Both terms and parts of the overall discussion explained more fully in Chapter 4.

222 Part Three Portfolio Management

Human-related assets have a particular meaning within the household or business framework. Typically that includes the income-earning ability of the individual measured by discounting anticipated future cash flows to a present value. Humans incur capital ex- penditures by investing in themselves. For example, either or both of you may obtain a bachelor’s or a master’s degree that raises your income-earning ability. You may take a course or engage in job training or learn how to better invest. With such actions, the pres- ent value of human-related assets usually goes up. However, because people work for only a finite number of years, at some point human assets decline, and by the time they fully retire, have no financial value at all. Human-related assets also include pensions such as Social Security, future gifts, and inheritances. They are human-related because they come about because of our efforts and relationships and stop when we pass away. Other assets include collectibles, antiques, jewelry, business interests, and other items that provide income or have market value. We don’t have to buy all the assets we use. In some cases, leasing is an alternative. Leasing is defined as acquiring the use of an asset without acquiring ownership. An ex- ample of a lease is renting an apartment or leasing a car for a number of years. Whether we lease or buy can involve many factors, including such items as a relative cost comparison, the amount of cash available, and, in the case of a home, tax aspects. I informed Amy and John that we would talk about the home separately at a later time. The home is an example of a durable good, but unlike the others, it may actually appreciate in value over an extended period of time. I emphasized that in the real world, people don’t use fixed financial calculations to cal- culate the most efficient items to the penny. Instead people think about the relative costs and benefits and make decisions intuitively. However, in many cases, such as buying versus leasing a car, more sophisticated calculations could be especially important.

Summary The household can be separated into financial and household investments. Household investments are the real and human-related assets that contribute importantly to the house- hold portfolio. They are the ones covered in this chapter.

• Our objective is to select the best mix of household assets overall. Investment returns can be measured on an individual-asset basis, within a household activity, or on a TPM basis. In this chapter, an individual-asset basis was used principally.

• Capital expenditures can be evaluated using either an NPV or an IRR approach. In each case, returns on projected outlays are compared with similar market-based investment returns. NPV uses market returns to develop current values and accepts all investments that have a positive present value. IRR provides a return that is compared directly with the market-based return that is used to accept or reject a proposed outlay.

• Real assets are often durable goods such as a car or an appliance. Human-related assets consist of job-related income discounted to the present plus those related to human work and other rights and relationships such as Social Security, corporate pension in- come, and anticipated gifts and bequests. Both use projected costs and benefits in deter- mining whether to make proposed outlays.

• Home ownership is an asset with unique characteristics. It often presents advantages over renting because of its tax benefits.

• Leasing is an alternative way to obtain use of an asset. It is generally more costly than purchase but is attractive for people who are short of capital or who desire more flexi- bility with their monies.

Chapter Eight Household Investments 223

Key Terms capital expenditures, 203 discount rate, 205 durable goods, 200 financial assets, 199 fully marketable assets, 199

human assets, 212 human-related assets, 200 internal rate of return (IRR), 208 lease, 215

net present value (NPV), 205 nonfinancial assets, 200 profitability index (PI), 207 real assets, 200 required rate of return, 205

studyfinance.com/lessons/capbudget Capital Budgeting This link has several sections whose topics include capital budgeting, capital expen- ditures, cash flow analysis, and valuation techniques such as NPV and IRR.

leaseguide.com Lease vs. Buy Decisions This site provides extensive information including up-front fees, interest costs, maintenance fees, and so on in lease-versus-buy capital expenditure decisions. A kit that allows users to calculate the obligations in leasing or buying decisions is also featured.

realtor.com/home-finance/financial-calculators/?source=web National Association of Realtors Here you’ll find multiple calculators including those for evaluating buy-versus-rent decisions, home affordability, and loan comparisons.

freddiemac.com Freddie Mac Two programs—one designed to provide adults with comprehensive homebuyer educa- tion and the other focused on helping homeowners protect their investment—are offered.

fanniemae.com Fannie Mae This Website promotes home ownership and provides information on financial prod- ucts and services that help families buy homes of their own.

nahb.org National Association of Home Builders (NAHB) Instructive information about home building and new house pricing is contained here. It serves as a guide for people interested in building, buying, owning, or remod- eling a home.


Questions 1. Describe the three approaches to decision making for capital expenditures. 2. Briefly explain total portfolio management (TPM).

3. Compare capital expenditures with marketable securities as an investment.

4. Why should capital expenditures be treated separately on a cash flow statement?

5. What are the strengths and weaknesses of the net present value (NPV) and internal rate of return (IRR) methods?

6. Why calculate a profitability index?

7. Why are durable goods considered to be capital expenditures?

8. Why is education a capital expenditure?

9. Contrast life cycle human-asset valuations for skilled and unskilled workers.

10. Compare capital budgeting practices as outlined in this chapter with those used on a day-to-day basis.

224 Part Three Portfolio Management

If the appropriate discount rate is 8 percent, what are the NPV and the IRR for this outlay?

Helen, a sociologist, is considering buying a new power lawn mower. It would save her 30 minutes of work a week, which she would use to see another client. Her fee is $16 per hour and she works 50 weeks a year. The lawn mower would cost $1,400. What would her IRR be if the mower was expected to last eight years? Express your figures on an annual basis and assume that her required rate of return is 9 percent.

Marcia had a choice of two washing machines of equal performance. One cost $400 and had a present value (PV) of $230 in savings over having clothes done through an outside service. The second cost $600 and had a PV of $450. Which one should she select?

Billy is considering enrolling in an MBA program. It would cost him $22,000 a year for two years. He believes it would raise his salary, which is now $50,000 a year, by the fol- lowing amounts:




11. What changes in day-to-day capital expenditure selections can you recommend?

12. Name three factors involved in the purchase of a car.

13. What factors should you consider when you aren’t sure whether to buy or lease a car?

14. What are the advantages of leasing over purchasing in general?

15. Why are more people leasing?

16. Is leasing less costly than purchasing? Explain.

17. Discuss the advantages and disadvantages of leasing a car.

Problems Laurence was presented with a capital expenditure for a furnace that would cost $12,000 today and would generate the following savings.


Year Amount

1 $2,000 2 $3,000 3 $2,000 4 $4,000 5 $5,000 6 $7,500 7 $5,000 8 $2,500

Year Amount

1–5 $15,000 6–10 20,000 11–15 25,000

Currently, Billy pays 28 percent of his salary in taxes; his tax bracket will change to 30 percent after the raise. Assuming that the required rate of return is 8 percent after taxes, should he make the investment? Use (a) the NPV method and (b) the IRR method to decide.

John is considering buying a new car for $15,000 if purchased today. He also could wait to purchase the vehicle three years from now for $18,000. If John can invest in the capital mar- kets and earn a 10 percent return, should he purchase the vehicle today or three years from now? John himself is indifferent about whether he to buy the car today or in three years.

As the owner of a business, you must make an investment decision. The investment will expand your company’s production plant at a cost of $1 million. The expansion will gener- ate income of $150,000 per year for 10 years; the required rate of return on the investment



Chapter Eight Household Investments 225

A. The after-tax IRR of this investment is

1. 17.41 percent.

2. 19.20 percent.

3. 24.18 percent.

4. 28.00 percent.

5. 33.58 percent.

B. Which of the following is/are correct?

1. The IRR is the discount rate that equates the present value of an investment’s expected costs with the present value of the expected cash inflows.

2. The IRR is 24.18 percent, and the present value of the investment’s expected cash flow is $9,200.

is 9 percent. What is the net present value NPV of the investment, and should you proceed with the expansion?

Item A has an NPV of $300 and an original cost of $500. Item B has an NPV of $350 and an original cost of $700. What is the profitability index (PI) of items A and B, and which is a more attractive investment?

Joan has a choice of purchasing a car for $20,000 with 9.7 percent interest cost to borrow and a three-year repayment period for leasing the vehicle. Leasing the auto would cost $300 a month for a three-year term. The sales tax is 6 percent. The car is expected to have a value of $14,000 at the end of the leasing period. Joan can obtain 7 percent after tax on similar marketable investments. Should she lease or buy the car?



Investment A costs $10,000,000 and offers a single cash inflow of $13,000,000 after one year. Investment B costs $1,000,000 and will be worth $2,000,000 at the end of the year. The appropriate discount rate or required rate of return is 10 percent compounded annu- ally. Match the investment(s) listed below with the corresponding financial information in the items that follow.

A. Investment A.

B. Investment B.

C. Both A and B.

D. Neither A nor B.

1. ___ The net present value (NPV) is $818,182 and the internal rate of return is 30 percent.

2. ___ The NPV is $818,182 and the internal rate of return is 100 percent. 3. ___ The NPV is $1,818,182 and the internal rate of return is 30 percent.

Smith invests in a limited partnership that requires an outlay of $9,200 today. At the end of years 1 through 5, he will receive the after-tax cash flows shown below. The partnership will be liquidated at the end of the fifth year. Smith is in the 28 percent tax bracket.



CFP® Certification Examination Questions and Problems

Years Cash Flows

0 ($9,200) CF0 1 $600 CF1 2 $2,300 CF2 3 $2,200 CF3 4 $6,800 CF4 5 $9,500 CF5

226 Part Three Portfolio Management

3. The IRR is 24.18 percent. For Smith to actually realize this rate of return, the invest- ment’s cash flows will have to be reinvested at the IRR.

4. If the cost of capital for this investment is 9 percent, the investment should be re- jected because its net present value will be negative.

a. (2) and (4) only

b. (2) and (3) only

c. (1) only

d. (1), (2) and (3) only

e. (1) and (4) only

Chapter Eight Household Investments 227

Case Application NONFINANCIAL ASSETS—CAPITAL EXPENDITURES Unlike Richard, Monica remained very concerned about their financial future. Specifically she was fearful that the couple would not have enough money to retire comfortably as they had expected. She asked whether she should postpone or eliminate one improvement on her house. She estimated that a new furnace with a useful life of eight years would cost $20,000 and would save $4,000 a year in heating bills.

Case Application Questions 1. Do we know yet whether Monica’s fears about retirement are justified? Do you have

any preliminary opinion about this?

2. Do you think she should consider a new furnace now?

3. Complete the furnace problem and give your response.

Appendix I

Capital Budgeting Theory In this appendix, we discuss capital budgeting theory first using the marginal rate of time preference and then considering consumption and capital expenditure decisions.

MARGINAL RATE OF TIME PREFERENCE Under the theory of choice, to help us decide how much to invest and how much to allocate to current spending, we need to consider our personal rate of time preference. It is the rate of return that makes us indifferent (exactly neutral) about the choice between spending to- day on a good or saving that money and spending it in the future. That rate varies with the individual. If you have a high rate of time preference, you would consume more today and save less. Those who have low incomes and not enough money to cover their basic needs16 and others who “live for today” may have higher-than-average rates of time preference. In making spending decisions, we use marginal rates because the same person may have different rates of time preference at different levels of income and spending. For example, people with low incomes would usually have a higher rate of time preference in postpon- ing spending on the first and only leisure time activity they could afford than they would if they had a higher cash flow and were considering forgoing their fourth leisure activity. We focus on the marginal personal rate of time preference, which we’ll simply call the mar- ginal rate of time preference. The marginal rate of time preference is compared with rates of return on investments to help determine whether to save or to consume. If you had a marginal rate of time preference

16 Emily C. Lawrence, “Poverty and the Rate of Time Preference: Evidence from Panel Data,” Journal of Political Economy 99, no. 1 (February 1991): 54–77. See also James Andreoni and Charles Sprenger, “Time Preferences from Convex Budgets,” American Economic Review, 2012, econ.ucsd.edu/~jandreon/ Publications/AER12-AS-Estimation.pdf

228 Part Three Portfolio Management

of 3 percent in considering an investment and could receive a 5 percent return on that invest- ment, you would be likely to save the money. Savings decisions are also influenced by other factors such as the need to accumulate assets for spending in retirement and, in a world that includes risk, the need for precautionary savings to provide for future uncertainties. Often the personal rate of time preference is not stated but implied by our actions. We can compute the marginal rate of time preference by comparing cash outflows today with cash outflows in the future using the following formula.

FV = PV11 + s2n where

s = Marginal rate of time preference n = Number of years

Example 8.A1.1 Brittany was contemplating taking a vacation at a seaside resort, which would cost $800. She could not decide between taking the vacation today and taking a vacation and a weekend trip costing $882 two years from now. Assuming that her preferred lifestyle expenditures include these two alternatives, what is her marginal rate of time preference? Based on her indifference as to whether to take the vacation today or two trips two years from now, Brittany has a per- sonal rate of time preference of 5 percent. If a 7 percent return is possible by investing in the capital markets, what should she do?

882 = 800 11 + s22

Inputs: 2 882–800

Solution: 5


Press i = 5%

Because the current market rate of return of 7 percent exceeds the 5 percent rate, she should save the money and use it to make two trips in two years. The 7 percent rate will actu- ally provide her with more than the cost of the trip in two years. She can use the extra money to purchase other goods and services.

CONSUMPTION AND CAPITAL EXPENDITURE DECISIONS We begin our capital expenditure discussions in a simple world that has perfect capital markets and no risk. In that world, outcomes are known with certainty; there are no infla- tion, taxes, or transaction costs; and all assets are fully marketable. And, very importantly, there is no difference between borrowing and investing rates. In theory, under perfect capital markets, consumption decisions are separate from capi- tal spending decisions. The consumption decision is determined by our personal rate of time preference. As mentioned, we save when market returns exceed the personal rate of time preference. We borrow when we have a desire for more consumption today and our borrowing rate is below our personal rate of time preference. Capital expenditure decisions in a world with perfect capital markets and no risk are based solely on market returns. We accept all capital expenditures whose returns equal or exceed the return on marketable investments. The reason is simple. We would have no incentive to make a capital expenditure if we could get a higher return by purchasing a marketable investment.

Calculator Solution

Chapter Eight Household Investments 229

Keep in mind that in this world without risk there are no defaults, there is no limit on the amount we can borrow, and the cost to borrow monies and the returns on investments are assumed to be the same. When we run short of cash flow to place in capital expenditures, we borrow enough money to fund the capital projects whose returns exceed the borrowing/ investing rate. Because there is no distinction between the rates to borrow and to invest and an unlimited amount of capital is available to borrow for either consumption or capital ex- penditures, the two decisions on whether to consume or to invest can be treated separately. We assume that we have a positive cash flow available to fund our investments. Let’s trace how equilibrium for investment occurs in this ideal state. Capital projects—the rates of return on internal investments—are arrayed from highest to lowest returns. These proj- ects are displayed in stepwise fashion because each capital expenditure has a different cash amount that is needed for investment. For example, you cannot buy one-half of a new furnace. Either you pay the full purchase price or you forgo the outlay. The rates of return on marketable securities, on the other hand, are level and can be selected in any size needed. As mentioned, equilibrium for capital expenditures alone occurs where its rate of return meets that for marketable securities. Clearly, marketable securities only come into play when there is cash flow available for external investment. If, instead of having money to invest, additional cash flows are needed, they would be supplied by borrowing along the borrowing/investing line again where the marginal rate of time preference intersects the line. (See Figure 8.A1.1.)

Example 8.A1.2 Greg has a rising marginal rate of time preference as savings increase; it amounts to 8 percent where it meets the borrowing/investing line. At that point, cash flows from household operations amount to $6,000. His choices for savings include four capital expenditures, for (1) $2,000, (2) $500, (3) $2,500, and (4) $1,000 returning 12 percent, 11 percent, 10 percent, and 6 percent, respectively. Assuming an 8 percent rate for borrowing or investing in an equilibrium market environment, how should Greg invest?

Rate of Return, %





1,000 2,000 3,000 4,000 5,000 6,000

Borrowing/Investing ($) 6



Borrowing, % Savings, %

–3 –2 –1 0 1 2 3 4 5 6

CapEx 3 C ap

Ex 2 CapEx 1

CapEx 4

Capital Expenditure Line




FIGURE 8.A1.1 Capital Expenditure Line

230 Part Three Portfolio Management

Greg will consider the following:

Amount Rate of Return

Capital expenditure 1 $2,000 12% Capital expenditure 2 $500 11% Capital expenditure 3 $2,500 10% Capital expenditure 4 $1,000 6% Total $6,000

Capital expenditures 1–3, totaling $5,000, exceed the market rate of return and are, therefore, funded. Because the fourth capital expenditure at its 6 percent rate is lower than the 8 percent market rate of return, it is not used. The remaining $1,000 of Greg’s cash flow is placed in marketable investments.

The equilibrium process is given in Figure 8.A1.1. Notice that point C in the figure delineates the point at which there is no borrowing or saving. Everything to the left of point C indicates borrowing; everything to the right, saving. The return on capital ex- penditures intersects the market line to the right, indicating that cash flow is available. Equilibrium for investing occurs at point A where it meets the borrowing/investing line. Point A indicates the amount of operating cash flow available for internal and external investing. Observe that the capital expenditure line starts directly above point A at the point of its maximum rate of return, point D, for capital expenditure project 1 (CapEx 1). The capital expenditure line then declines as succeeding capital projects—CapEx 2, then CapEx 3— offer lower and lower returns until the line meets the borrowing/investing line at point B, its equilibrium point. The horizontal distance between points A and B delineates the amount of capital expenditures used and between B and C the amount of marketable in- vestments used. Proposed capital expenditures below the return on marketable securities that are rejected are shown as a dotted line. If the borrowing/investing line were changed from the 8 percent return figure shown to 11 percent, capital expenditures would decline as external investments proved more attrac- tive relative to capital outlays. If the investment return on marketable securities were to be lowered instead of raised, the opposite effects would occur.

PRACTICAL ADJUSTMENTS Once we use more practical assumptions, the situation changes somewhat. Transaction costs for buying and selling securities and taxes on income are now part of the process. Moreover, in real life, risk is usually present in making decisions—we cannot be sure of any outcome. As a result, there is a difference in the borrowing and the investing rates as anyone who has both credit card debt and a position in a stock knows. We must accept fluctuations in performance whether that means the possibility of purchasing a car that is a “lemon” or investing in a stock that provides losses instead of gains. In this more realistic environment that includes risk, we cannot be sure how much money we will need to save for future consumption. We allocate extra money for precau- tionary savings to make more likely our ability to fund day-to-day and long-term retirement needs in the face of uncertainties. We are no longer able to borrow unlimited amounts of funds at the low risk-free rate. Instead, the borrowing will include an extra cost for risk, which will increase as the amount of money borrowed increases. Decisions on the amount to consume and the amount to invest will be made together. We discussed borrowing and its effect on consumption and investment in Chapter 7.

Chapter Eight Household Investments 231

Appendix II

Assumed Rents Assumed rents are hypothetical costs for assets owned. They are hypothetical costs be- cause they are not paid to anyone. Because no cash is transacted, these rents are not nor- mally considered financial outlays and are not tax deductible. Nonetheless, that can be a useful tool in analyzing capital expenditures for items such as durable goods. Economists call these costs implicit costs. They are rents that would have to be paid to obtain the use of an asset if we had not purchased it outright. When we buy something, we can be consid- ered both owners of an asset, for which we would want to be compensated, and renters of the asset, but we rent the asset from ourselves. Looking at an asset in this way can aid in establishing costs and its fair market value. For example, if you bought a television, its implicit cost would be how much it would cost you to rent that set. The value of that television could be considered the NPV of all of its yearly implicit costs while in use. Analyzing implicit costs can shed some light on durable goods—for example, a house. When you buy a house to live in, you are both an owner who has invested in a home and the user of that home. If you divide the transaction into two parts, you can better under- stand the cost and the investment portion. The housing buy-versus-rent example in Appendix I of Chapter 9 Real Estate and Other Assets Appendix I includes the implicit rental cost in obtaining the investment return on owning it. Thus, your total cost of operat- ing a home could be considered not only the costs of electricity, heat, gardening, and so on, which are not generally covered in a rental, but also the implicit rental cost, which is equivalent to how much you would pay to rent a similar property.

Appendix III

Understanding the Lease Payment A lease payment has three parts. The first is the finance cost, the sum you pay to cover the borrowing cost and profit for the company that purchased the car and leased it to you. The second is the depreciation cost, the amount by which the market value of the car is ex- pected to decline over the lease’s life. The third is applicable taxes on purchase of the lease. Let’s take each separately in calculating the lease payment.

FINANCE COST The finance cost is expressed as a money factor. The money factor is the interest rate by custom divided by 2,400. The interest rate charged over the life of the lease is called the base interest rate.

Factor Explanation

Finance Factors Money factor The interest rate charged over the life of the lease, which is called the base

interest rate. By custom, this rate is expressed as a decimal obtained by dividing the base rate by 2,400.


232 Part Three Portfolio Management


Monthly leasing price = Depreciation factor + Finance factor + Tax factor Monthly leasing price 1K2 = G + 1 + T

Depreciation factor 1G2 = A − 1B × D2 C

Finance factor 1I2 = 1A + 1B × D2 2 × E Tax factor 1T2 = 1G + I2 × F


A = Actual sales price B = Manufacturer’s suggested retail price (MSRP) C = Number of months D = Residual value as percent of MSRP E = Money factor (interest rate divided by 2,400) F = Actual tax rate G = Depreciation factor I = Finance factor T = Tax factor

Example 8.A3.1 Brad wanted to calculate the monthly payment for leasing a car. The negotiated price for the car for lease payment purposes was $30,647, down from the list price (MSRP) of $32,455. There was no down payment. The interest rate was 3 percent and the residual for a 39-month lease was 56 percent. What is the monthly payment assuming a 9 percent sales tax?

Money factor = 3%

2,400 = 0.00125

Monthly leasing price = Depreciation factor + Finance factor + Tax Factor

Factor Explanation

Selling price The actual cost of purchasing the car. Sometimes called the capitalized cost. MSRP The list price of the car. Depreciation Factors Residual value The assumed value of the car at the end of the lease period. It may be

expressed either as an amount or as a percentage of the list price. This value is the price you will pay should you want to purchase the car after expiration of the lease.

Calculation Depreciation expressed as an amount is divided by the number of months in the lease. Depreciation is the negotiated sale price less the residual value.

Tax Factors State and local taxes The taxes based on leasing the car. Often these taxes are lower than those

for purchase since lease payments are not made on the full value of the car. Calculation Total taxes divided by the number of months in the lease to obtain the

monthly tax.


Chapter Eight Household Investments 233

Depreciation factor 1G2 = A − 1B × D2 C

= 30,647 − 132,455 × 0.562


= 12,472


= 319.80

Finance factor 1I2 = 1A + 1B × D2 2 × E = 130,647 + 132,455 × 0.562 2 × 0.00125 = 61.03

Tax factor 1T2 = 1G + I2 × F = 1319.80 + 61.032 × 0.09 = 34.27

Monthly leasing price = 319.80 + 61.03 + 34.27

= 415.10

Appendix IV

Buy versus Lease—Car In this example, we consider how to arrive at a financial decision about whether to buy or lease a car when lease payments are known.

Example 8.A4.1 Diane was interested in the Del Phillipo, an Italian sports car that came in one color—red. A car of that type was relatively inexpensive at $45,000. Diane was not sure whether she would keep the car for three years or six years. Consequently, she reviewed lease quotations for both periods. The dealership indicated that the cost for leasing for either period would be $650 a month claiming that although the car’s market value was higher after three years, it’s value would drop more precipitously after that time. On her own, Diane made estimates of a market value of $30,000 after three years and $15,000 after six years. The normal automobile warranty would cover special car problems such as engine troubles, air conditioning not working properly, or overall electrical problems. Diane would have to pay for normal wear and tear such as changing tires and brakes whether she leased or purchased the car. Therefore, she didn’t include such costs in her analysis. However, she did include a special $2,000 charge for a repair in the fifth year when she figured that her warranty, based on mileage, would run out. Assume no down payment, a 6 percent borrowing rate for a car loan on purchase to be repaid over six years, and a sales tax of 5 percent. Assume there are no considerations other than return and that Diane’s required rate of return is 6 percent. Use both a three-year and a six-year period. Calculate monthly payments, but use yearly figures for calculating IRR for both purchase and lease. Should she buy or lease?

234 Part Three Portfolio Management

Three-year return = 6.0% Six-year return = 10.7%

Ownership operating advantage = Buy cost − Lease cost

In year 1 there is a $2,250 tax cost and in year 5, we add $2,000 extra repair cost to the annual loan payment. Balance debt for the three-year period equals the ownership operat- ing advantage for each year except for year 3, when the ownership operating advantage is subtracted from the market value of the car in year 3. The same approach is used in calcu- lation of the balance debt for the six-year period.

Car Buy versus Lease

Inputs Auto Loan Repayment (3-year period)

Purchase price $45,000 Monthly payment $1,369 Market value in three years $30,000 Annual payment $16,428 Market value in six years $15,000 Repair cost in year 5 $2,000

Auto Loan Repayment (6-year period)

Monthly lease payment $650 Monthly payment $746 Annual lease payment $7,800 Annual payment $8,949

Tax Cost on Purchase

Annual interest rate 6% Tax cost (5% on purchase price) $2,250 Monthly interest rate 0.5% Sales tax 5% Required rate of return 7%

Year 1 2 3 4 5 6


Yearly payment (3-year period) $16,428 $16,428 $16,428 Yearly payment (6-year period) $8,949 $8,949 $8,949 $8,949 $8,949 $8,949 Tax and extra repair costs $2,250 $2,000


Yearly payment $7,800 $7,800 $7,800 $7,800 $7,800 $7,800 Ownership operating $10,878 $8,628 $8,628 advantage (3-year period) Ownership operating $3,399 $1,149 $1,149 $1,149 $3,149 $1,149 advantage (6-year period) Market value of the car $30,000 $15,000 Balance debt (3-year period) ($10,878) ($8,628) $21,372 Balance debt (6-year period) ($3,399) ($1,149) ($1,149) ($1,149) ($3,149) $13,851

Calculation Explanation

Auto Loan Repayment (six-year period)

72n (6 years × 12 months), 0.50i (6% ÷ 12 months), 45000 PV Press PMT = 746 Monthly loan payment Annual loan payment = 746 × 12 = 8,949 Yearly loan payment Auto Loan Repayment (three-year period)

36n (3 years × 12 months), 0.50i (6% ÷ 12 months), 45000 PV Press PMT = 1369 Monthly loan payment Annual loan payment = 1369 × 12 = 16428 Yearly loan payment Annual lease payment = 650 × 12 = 7800

Chapter Eight Household Investments 235

The return for purchasing for three years (6 percent) does not meet the 7 percent required rate. However, the six-year rate substantially exceeds it. Therefore, it pays to lease a car for three years but to buy for the six-year period. Over the longer period of time, the ability to own and sell an asset more than offsets the extra monthly cost for the purchase.

Appendix V

Excel Examples for NPV and IRR17 This appendix demonstrates how you can solve problems involving NPV and IRR methods by using Excel.

NET PRESENT VALUE Often we face investment decisions involving capital outflows and cash inflows in different periods. Few investments have even cash flows in each period. We cannot use Excel’s PV and FV functions for uneven cash flows because they assume equal payments or a lump sum. If we want to solve for the present value of uneven cash flows, we need to use the NPV. We use two methods for solving NPV problems: a time line and the Excel NPV function.

Example 8.A5.1 Capital expenditure requires a current investment of $5,000 and yields future expected cash flows of $1,200, $1,500, $1,800, $1,300, and $1,100 for the next five years. The required rate of return on the investment is 8 percent. What is the net present value of the investment, and should you undertake it (see Figure 8.A5.1)?

Three-Year Return

CF Clear the register f FIN 2nd CLR Work Enter cash outflow year 1 10,878 CHS g CFo 10,878 +/− ENTER ↓ Enter cash outflow year 2 8,628 CHS g CFj 8,628 +/− ENTER ↓ ↓ Enter cash inflow year 3 21,372 g CFj 21,372 ENTER ↓ ↓

Calculate the internal rate of return f IRR IRR CPT 6.0% 6.0%

General Calculator Approach HP12C TI BA II Plus

17 Troy A. Adair, Excel Applications for Corporate Finance (New York, NY: Burr Ridge: McGraw-Hill/Irwin, 2005), and Craig Holden, Excel Modeling in Investments, 4th ed. (Princeton, New Jersey: Prentice Hall, 2011).

Six-Year Return

CF Clear the register f FIN 2nd CLR Work Enter cash outflow year 1 3,399 CHS g CFo 3,399 +/− ENTER ↓ Enter cash outflow years 2–4 1,149 CHS g CFj 1,149 +/− ENTER ↓ Enter number of years 3 g Nj 3 ENTER ↓

Enter cash outflow year 5 3,149 CHS g CFj 3,149 +/− ENTER ↓ ↓ Enter cash inflow year 6 13,851 g CFj 13,851 ENTER ↓ ↓

Calculate the internal rate of return f IRR IRR CPT 10.7% 10.7%

General Calculator Approach HP12C TI BA II Plus

236 Part Three Portfolio Management

Building This Excel Model

1. Inputs. Enter the required rate of return as Discount Rate in cell B4. Build a table enter- ing cash outflows (or current investment) in cell B6 and cash inflows (or future ex- pected cash flows) in cells C7:G7.

2. Net present value using a time line. We have a period 0 when current investment oc- curs and five consecutive future periods with the expected cash flows (see Figure 8. A5.2). Create a time line from period 0 to period 5 by entering 0, 1, . . . , 5 in the range B10:G10. Enter the corresponding cash flows in periods 0 through 5 in the range B11:G11. For your convenience, just copy the values from the Inputs table. Next calcu- late the present value of each cash flow using the formula for present value:

Present value = (Cash flow)/((1 + Discount rate)^Period)

Enter =C11/((1+$B$4)^C5) in cell C12 and copy it across to cell G12. The $ signs in $B$4 lock the column and row when copying. Put the same value in cell B12 as you do in cell B11 because this cash flow occurs in the current period, so you don’t need to discount it. Net present value is the sum of the present values of all cash flows. Enter SUM (B12:G12) in cell B13.

3. Net present value using the Excel NPV function. The NPV function calculates the net present value of a stream of cash flows. It has the following format:

NPV (rate, range of values)

The important thing that we should note here is that the NPV function discounts cash flows starting in period 1. Therefore, we must add the present value of the period 0 cash flow to the net present value of the cash flows for periods 1–5. Enter =B6+NPV(B4,C7:G7) in cell B16.

1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17

A B C D E F G Net Present Value

Inputs Discount rate 8% Period 0 1 2 3 4 5 Cash outflows ($5,000) Cash inflows $1,200 $1,500 $1,800 $1,300 $1,100

Net Present Value Using the Time Line Period 0 1 2 3 4 5 Cash flows ($5,000) $1,200 $1,500 $1,800 $1,300 $1,100 Present value of cash flows ($5,000) $1,111 $1,286 $1,429 $956 $749 Net present value $530

Net Present Value Using the Excel NPV function Net present value $530



FIGURE 8.A5.1 Excel Model for Net Present Value

($5,000) $1,200 $1,500 $1,800 $1,300 $1,100

0 1 2 3 4 5

FIGURE 8.A5.2 Finding PV of Future Cash Flows

Chapter Eight Household Investments 237

The net present value of this investment is $530, which is a positive number. Therefore, you should accept the capital expenditure.

INTERNAL RATE OF RETURN Often we need to determine the yield of an investment given its cost and cash flows. The IRR approach helps us to solve for the yield of an investment. In the following example, we demonstrate the use of the Excel IRR function.

Example 8.A5.2 A project requires an initial investment of $10,000 and yields future expected cash flows of $1,800, $2,000, $2,200, $2,500, $1,900, and $1,700 in the next six years. If the required rate of return of the investment is 9 percent, what is the IRR, and should we undertake this project? (See Figure 8.A5.3.)

Building This Excel Model

1. Inputs. Enter the required rate of return in cell B4. You don’t need it in your calcula- tions, but it is convenient to have it there when evaluating your project. Build a table entering cash outflows (or initial investment) in cell B6 and cash inflows (or future ex- pected cash flows) in cells C7:H7.

2. Internal Rate of Return Using the Excel IRR function. The IRR function calculates the internal rate of return of a stream of cash flows. It has the following format:

IRR (range of values, guess)

Range of values is a range of cash flows including the investment cost, and guess is the optional first guess at the correct rate of return. Generally, it can be omitted. Create a table with the periods from 0 to 6 and corresponding cash flows. Enter =IRR(B11:H11) in cell B13.

The project’s internal rate of return (6 percent) is less than the required rate of return (9 percent). Therefore, you should reject this project. Note that in the original example, there is only one sign change in the cash flow stream (from negative in period 0 to positive in period 1 and thereafter). Generally, there will be one IRR solution to the problem for each sign change. If there is more than one sign change, you should use the second parameter of the IRR function, guess, to find all the solutions to the problem. By adjusting the guess, you can identify all the IRRs.

1 2 3 4 5 6 7 8 9 10 11 12 13

A B C D E F G H Internal Rate of Return

Inputs Required rate of return 9% Period 0 1 2 3 4 5 6 Cash outflows ($10,000) Cash inflows $1,800 $2,000 $2,200 $2,500 $1,900 $1,700

Period 0 1 2 3 4 5 6 Cash flows ($10,000) $1,800 $2,000 $2,200 $2,500 $1,900 $1,700

Internal rate of return 6%

Internal Rate of Return Using the Excel IRR function


FIGURE 8.A5.3 Excel Model for Internal Rate of Return


Chapter Goals

This chapter will enable you to:

• Understand the characteristics of investments in types of real estate.

• Assess the strengths and weaknesses of real estate.

• Value real estate structures.

• View the home as an investment.

• Review the investments in commodities including gold.

• Place real estate and commodities within an overall portfolio basis.

Laura said, ”Congratulate us; I am pregnant again.” I thought to myself that this might be only one additional child, but it was a whole new ballgame as far as near-term planning was concerned. The first area we would have to work on was the home.

Real-Life Planning

Sebastian was a well-known film producer. He created motion pictures from one simple paragraph. His success came from delivering films that had wide appeal because of their similarity with life circumstances but with a little twist or reflection of very recent changes in human values. But Sebastian wasn’t happy just producing films. As a hard-driving person, he looked for a hobby, one that could provide a return on his time. He decided on real estate. He was friendly with the affluent creative set who had primary residences or vacation homes that reflected their money and desires for individual tastes. In one extreme example, he observed a home built as a medieval castle together with moats and marble floors and ceilings. It cost millions to build but sold for $15 million. Sebastian had long before decided to try real estate himself but on a small scale. He would renovate existing homes, making them appealing to people with taste for what he would offer. He started by looking for homes that were depressed in value. They would be cheaper because the overall market was temporarily depressed or because the property had some fundamental flaw, such as being a modern home in a community of colonial homes. Sebastian did very well in his new business and it allowed him to relax from the day-to- day pressures of making hit films. He was able to walk into a home for sale and instantly visualize how to make it appealing. He always paid attention to where the property was

Chapter Nine

Real Estate and Other Assets

Chapter Nine Real Estate and Other Assets 239

situated, purchasing a less costly home in an expensive neighborhood rather than a luxuri- ous one in a less desirable community. He was therefore following the old real estate adage that the three most important things in selecting a property are location, location, location. Because Sebastian’s hobby/business occurred during a period of strong gains in the real estate market, he questioned whether the strong market largely accounted for his profit- ability. When the real estate market crashed, he got his answer: He was left with a home he had previously purchased, and it was worth much less than he had paid for it. He never blinked. He went ahead renovating the home that was located next to a lake, an appealing aspect for his targeted buyer. The home lingered on the market. He then reintroduced the property at an open house and invited the press. He presented an appealing story of its in- dividualized charms. The resulting publicity resulted in multiple bids. Sebastian had taken some of the same techniques he had used for films—the visualiza- tion of what motivated people, the Hollywood set, and an ability to create publicity—to make his spare-time hobby into a large money earner. From a total portfolio management perspective, these household assets are considered nonfinancial. Real assets refer to real estate and the home whereas commodities and gold are included as other assets. Their functions in the household portfolio differ. The home is a basic heavily weighted asset in a majority of household portfolios. When used, com- modities and gold diversify a portfolio’s options with their risk management function.


In previous chapters, we discussed human and household assets as investments, and in the next one we will detail traditional financial investments such as stocks, bonds, and mutual funds. In this chapter, we discuss principal remaining areas, real estate and then touch on commodities including gold. Real estate is the most valuable asset that many people have. However, a good num- ber of homeowners don’t even regard it as a growth investment, preferring to think of it as a booster of their quality of life. It is, of course, both. Anyone who disregarded its investment characteristics or who mistakenly thought it always increased in value was in for a rude awakening as overinflated real estate values and the high level of debt connected to it caused the recession of 2008–2009. The process of adjustment and normalization is taking place over many years, following the deepest U.S. recession since the 1930s. In the chapter, we discuss the forms of ownership and types of real estate, including their strengths and weaknesses and how they are valued in the marketplace. Given its importance in household portfolios, we pay particular attention to homes and begin our discussion with it.


The home is a special investment because it serves many functions and has many features, and we explain how to appraise it as an investment. The home is a structure whose traditional function is to shelter its occupants. However, ownership of a home, whether it be a condominium, a townhouse, a duplex, or a stand-alone house, often carries significant symbolism. Some of the associations and feelings it can convey are achievement, stability, privacy, and comfort. Whether bought or rented, a townhouse or a house generally signifies a single financial structure for all its inhabitants. This unified structure allows us to utilize a household framework for financial planning purposes.

240 Part Three Portfolio Management

Housing Features The house has a number of features that distinguish it from most durable goods.

1. Unique physical characteristics. No two houses are exactly the same and when taking into account furniture, fixtures, and decoration most can readily be distinguished from others.

2. Long lives. Houses tend to have extended useful lives. Although the components of a house depreciate, its overall asset value often can be prevented from declining for many years by maintaining and renovating it.

3. Tax benefits. One government goal is affordable suitable housing for all Americans. The government provides tax benefits to owners, offers programs for mortgage financing, and subsidizes low-income housing.

4. Appreciation potential. Many properties that are well maintained tend to rise in value over time.

5. Fixed locations. Generally, houses remain in one place compared with durable goods, which can be moved around. As a result, a house’s location takes on significance in its market valuation.

6. Land. The house sits on land that, in most instances, is owned. Land may fluctuate in value, but over a long period of time, its value tends to rise when a house and the land it is on are considered a single asset. Unlike other durable goods, even over extended periods, these properties seldom lose their entire value.

Housing Uses Home ownership is normally an individual’s largest single cash expenditure. Multiperson occupancies, as, for example, in marriages, carry significant efficiencies because the costs of shelter can be shared. The home is also one of the clearest examples of multiple uses. Its first use is its classic role of providing shelter. In this role, it has ongoing cash maintenance costs for such items as utilities and repairs; work time must be expended for upkeep of the house. Moreover, the home requires periodic capital expenditures, such as putting on a new roof or buying a new furnace, to sustain it.1 The home’s second use is as a long-term investment. A well-maintained house can appreciate substantially over time. Its third use is in providing pleasure to its occupants. Among its benefits are relief from daily stresses and the ability of household members to express themselves in putting the entire house together according to their taste and then maintaining it as an attractive place to live. Because of the early 21st century housing boom and its subsequent bust, the rate of U.S. home ownership reached a peak in 2004 at 69.2 percent but has slipped since then (see in Table 9.1).

Mortgages Mortgages are an important part of the home as an investment process. They allow people with a continuing salary to finance a large portion, often 80 percent of the purchase price of the home, subject to limits as a percentage of their income. The method has placed the majority of Americans in homes with 15 or 30-year repayment schedules. Mortgages have allowed people to enjoy home ownership earlier than if they had to pay the entire price at purchase. Moreover, the use of debt can raise the return on investment for the home. Mortgages are one of the only forms of private borrowing whose interest payments the government allows to be tax deductible.

1 Most people refer to a house as real estate or property, not as a durable good. We distinguish it here from other types of household assets and treat it separately from durable goods throughout the book.

Chapter Nine Real Estate and Other Assets 241

See Chapter 7 for a more in-depth discussion of mortgages including the advantages and disadvantages of fixed rate versus variable rate.

Tax Benefits As mentioned, the government recognizes that owning a home is a primary goal of many people. Home ownership presents significant tax benefits because interest on a home mort- gage is tax deductible as are property taxes. The interest deduction is limited to the first $1 million borrowed on a home. In addition to its investment assets, appreciation in its value is not taxed until the home is sold. Upon sale, the first $250,000 of gain per individual taxpayer or $500,000 per married couple is tax free; amounts over that are taxed at capital gains rates. Capital expenditures on home improvements are added to the purchase price in calculating the owner’s basis in the property, which reduces the ultimate gain. This $250,000 or $500,000 benefit is allowed once every two years for those people who have had their home as their primary residence for any two of the past five years.

Example 9.1 Toby and Vicki Walker held their home for six years. During that time, they paid a total of $40,000 for capital improvements, including a bathroom renovation and installation of central air conditioning. This increased their basis in the home (their cost, for tax purposes) from $200,000 to $240,000. Then they sold the house for a net price of $320,000, which was an $80,000 gain: $320,000 net sale price minus their $240,000 basis. Married couples are al- lowed up to $500,000 of tax-free gains on sale of a principal residence, so the Walkers owe no income tax on their $80,000 housing profit.

Because tax benefits can be highly significant, individuals must take care to explicitly include them in decision making. They are incorporated in the market price of individual homes. A comparison of traditional durables with the home is shown in Table 9.2.


1965 63.4% 1970 64.0% 1975 64.5% 1980 65.5% 1985 63.5% 1990 64.1% 1995 65.1% 2000 67.5% 2004 69.2% 2005 69.0% 2010 66.5% 2011 66.0% 2012 65.4% 2013 65.2% 2014 64.0%

TABLE 9.1 Home Ownership Rates

Source: Federal Reserve Economic Data, https:// research.stlouisfed.org/fred2/ series/RHORUSQ156N#

Factor for Comparison Traditional Consumer Durables House

Market value Depreciates Generally appreciates if well maintained

Characteristics Uniform appearance Individually finished

Life Limited Long

Tax benefits Generally none Substantial

TABLE 9.2 Summary Table of Traditional Durables versus House Durable 

242 Part Three Portfolio Management

One way to quantify the financial benefits of a home is to include the cost of renting it in the calculation of return. In effect, when purchasing a home, the buyer can be consid- ered to have rented the home to himself or herself (see Appendix II in Chapter 8 on assumed rents for more information). The outcome is that the buyer saves the cost of renting the home. Annual returns would then be:

Return on house for the period

= value during period Increase in house

+ Rent not paid − Cost of upkeep

Market value of house, beginning of period

Example 9.2 Sandy owned a home that was worth $100,000 at the beginning of the year and $114,000 at year’s end. The same house could be rented for $16,000 per year. Upkeep cost Sandy $2,000 for the year. What is his return for the year?

Return on house = 1114,000 − 100,0002 + 16,000 − 2,000


= 28,000


= 28%

The value of an individual home is influenced by factors such as the status of the neigh- borhood, the style of the home, how well it is maintained, and its proximity to a business area. Because constructing a home is very labor intensive and factory mass production techniques are not generally used,2 few technological developments provide efficiencies in building new homes or remodeling older ones. Given its long useful life, purchasing a previously occupied home should not hold a stigma as there might be among purchasers of second-hand durables such as “used cars.” Therefore, new home prices strongly influence existing home prices. New home prices in turn reflect changes in wage rates for construc- tion workers and increases in raw material costs needed to build the home.3

Affordability Whether the purchase of a home is realistic and, if so, how much the buyer can afford to pay depends on several factors:

• Current income. Obviously, the more a person earns, the more he or she should be able to afford.

• Tax bracket. Ironically, the higher a person’s tax bracket, the higher is the “govern- ment subsidy” for tax-deductible real estate taxes and interest expense, and the more expensive is the home that can be bought.

• Liquid assets and debt accumulated. With a down payment of 25 percent or more, a person can purchase a higher cost home and may still have lower ongoing demands on household cash flow. On the other hand, the higher the amount of nonmortgage debt outstanding, the lower are the allowable overhead costs for the home, and therefore the home price that is affordable is lower.

• Value system. The more important a home is to someone, the greater the sacrifice in other areas the person is willing to make; thus, she or he can afford a higher-priced home.

2 Lower-quality mobile homes are an exception. 3 In addition, increases in the discretionary income that people have can result in building more expensive homes. For example, homes built in recent decades are larger in size, reflecting changes in taste that probably result from increased amounts of disposable income.

Chapter Nine Real Estate and Other Assets 243

• The local realities. Homes vary in price in different markets. A home in San Francisco can cost five times the same home in rural Ohio. The reality is that many people who live close to a major city in the Northeast or on the West Coast probably violate the affordability rule we explain later.

• Outlook. The more optimistic a person is about future income and the price apprecia- tion of real estate, the higher the outlay he or she willing to make.

• Risk tolerance. The higher a person’s risk tolerance, the higher is the mortgage payment he or she is willing to assume relative to available cash flow.

Clearly, there is no quick and easy answer to how much home a person can afford. The most common guide—the one used by banks in many situations—is to determine the amount of mortgage-related expenses, real estate taxes, insurance, and interest and princi- pal payments on a mortgage. The total figure for mortgage-related costs should not exceed 28 percent of a person’s total income. When other debt-related interest and principal pay- ments are added in, the total cost should be no more than 36 percent of total income. In expensive areas, that figure can be exceeded, however. During the peak of the housing boom, in the early years of this century, banks often became very lenient about minimum down payments. Subsequently, after many low down-payment loans went into default, most lenders resumed insisting on down payments of as much as 20 percent on a principal residence. Still, lenders may be more liberal about affordability issues if the buyer is will- ing to pay an extra fee that purchases insurance protecting the bank against default.

Example 9.3 Hanna was very interested in finding out whether she could afford the house she was consider- ing. The mortgage payments were $1,000 a month; the taxes and insurance on the home were $3,600 per year. Hanna earned $60,000 per year before taxes and had no other debt. Could she qualify for a bank loan and afford the home?

Hanna’s actual costs are below the allowable level. She qualifies for purchase of this home.

Calculations Explanation

Gross income before taxes $60,000 Allowable percent of income 28% Allowable housing costs 16,800 0.28 × 60,000 Actual annual mortgage costs $12,000 12 × 1,000 Taxes and insurance $3,600 Total yearly cost $15,600

Buy versus Lease—Home The buy-versus-lease decision for housing is somewhat sophisticated but can be handled without much difficulty. The details for leasing versus buying a home are in the purchase decision; the cost to rent is given with no opportunity to find an identical home at a lower lease price as can be done for a car. The weakness in taking a less sophisticated approach to decisions about housing is discussed here.4

See Appendix I for a buy-versus-lease example.

4 In a purely competitive market with no transaction costs, no difference between borrowing and lending costs, and no taxes, the costs of ownership including an appropriate return on owner’s capital invested in the property would equal the cost to rent. However, in reality, the fact that the government subsidizes housing costs and allows the sheltering of capital gains on sale will shift the balance toward home ownership. Other considerations also alter the buy versus lease choice.

244 Part Three Portfolio Management

Clients frequently ask their financial planners and accountants whether it is better to rent or own, given their particular circumstances. The decision is generally made by comparing after-tax costs of a purchase with those of renting in the first year only. No consideration is given to the opportunity cost for the down payment—the amount that could have been earned if it had not been used as a cash deposit on the home. Frequently, the potential yearly appreciation in the home is not included ei- ther. Moreover, the amount of the mortgage pay- ment that is applicable to repayment of debt is treated as an expense. This simplistic way of look- ing at the rent-or-buy decision can lead to the wrong decision. The correct method is not much more difficult. It incorporates all the same factors using the proper marginal tax bracket for combined federal, state, and local taxes. Instead of a one-year analysis, it uses a multiyear framework. One reason this is preferable

is that the benefits of buying rather than leasing in- crease over time; that is so because the mortgage payment stays the same while the interest expense actually goes down as opposed to rental costs that often increase in subsequent years. When the time frame for holding the home cannot be estimated with some realism, a seven-year period that often approximates the holding period for the average homeowner can be used. Perhaps most important, a true capital budget- ing perspective should be used with the internal rate of return (IRR) or net present value (NPV) to determine a projected rate of return. These techniques apply to one of the most important investment decisions—whether to buy or rent a house or, alternatively, which arrangement offers a higher return. It is a prime example of the benefits of the IRR–NPV calculation and the overall rational financial approach for household capital expendi- tures explained in this chapter.

Practical Comment Analysis of Rent versus Own

Including a house as an investment can be more involved than it looks. Its full cash value can’t be determined without selling it. This involves moving out and perhaps renting another residence. A partial solution can be to take a reverse mort- gage, which provides cash proceeds up to a certain limit while the owner lives in the house. People not willing to move or to borrow against a home later in life, as many people aren’t, incorpo- rate a home in their investment portfolio should be thought through carefully. On the one hand, in the event of extreme financial circumstances, a home can be sold and or borrowed against. On the other

hand, people often lower their standard of living to remain in their house. In that case, the house becomes an asset for their heirs. If a client is unwilling to move or to borrow money against a house, advisors may include it as an asset on the balance sheet but exclude it in assessing capital available for retirement needs. Alternatively, and perhaps preferably, an advisor may project using a house for its potential cash proceeds only in the event that its occupants live a longer than usual life—for example, into their 90s. At that time, many people would be compelled to move into an assisted- living facility anyway.

Practical Comment When to Consider a Home an Investment

Overall Appraisal of the Home as an Investment As the buy-versus-lease example in Appendix I shows, the return on investment on the purchase of a home can be highly attractive. This should not be surprising because the government provides tax benefits for a home’s interest and property tax deductions. Another advantage of the purchase is that there may be no tax on the gain from a

Chapter Nine Real Estate and Other Assets 245

5 The criterion should be the marginal tax bracket. Marginal means the tax on the next dollar earned. Substantial might be a marginal bracket of 20 percent or more. See Chapter 14 for an explanation of marginal taxation.

The advantages and disadvantages of owning a home were stated in the preceding section. Let’s extrapolate and summarize the most important contributors to whether to become a home owner and look at an investment in a home on an overall household portfolio return-risk basis.* Then you can draw an overall conclusion. Often the main reason that investing in home ownership has higher returns than renting and invest- ing the difference in financial assets such as stocks is the tax advantage from home ownership. These ad- vantages include deductions for interest, real estate taxes, and reduction or elimination of taxes on a gain on sale of the home. In comparisons of buying versus renting, be sure to add to benefits the typical rental cost you would normally pay if you didn’t own and add to costs maintenance costs for home ownership.

Overall, the home has favorable return potential that is enhanced by the use of debt. Its risk is moder- ate, placing it between stocks and bonds. The fact that a home is not very sensitive to drops in stock and bond prices and that it is a good hedge against inflation help reduce its risk. All in all, the home is a highly effective invest- ment from a household portfolio perspective. More simply, over extended periods of time, owning a home has generally been one of the most highly re- warding investments a household can make and, ex- cept for major unforeseen circumstances, is likely to remain so in the future.

* See Chapter 8 including Figure 8.1 for a summary of household assets.

Professional Advice Attractiveness of Home as a Portfolio Investment

home’s sale. Assuming reasonable maintenance costs, the two key factors in making the purchase of a home a generally attractive investment are (1) tax benefits, espe- cially when the buyer is in a substantial tax bracket5 and (2) the continued increase in the value of the house at near the inflation rate—in some cases, significantly beyond that rate. Thus, the house can provide a hedge against inflation and a return on the in- vestment. An unanticipated acceleration in inflation could raise the rate of return be- cause, as mentioned, the house would likely rise in value as would the higher cost of building new homes. Thus, the home deserves its reputation as a good hedge against inflation. Other factors that people who purchase homes instead of renting them find appealing are pride of ownership and their forced savings feature. Mandatory repay- ment of debt as stated in the mortgage contract is a savings and investment feature that many people overlook. Rental advantages include the flexibility of changing the dwelling site and the lack of a capital commitment. The disadvantages of home ownership include (1) its lack of short-term liquidity should an immediate sale become necessary, (2) the responsibility for maintaining the home and grounds, and (3) the cyclical nature of home prices. Such cycles and the lack of short-term liquidity can result in a loss when, for example, shortly after the purchaser of a home experiences an unexpected change in work location, requires the sale of the home. As many homeowners learned during the housing collapse of 2008 and in the following years, the combination of a reduced home value and sizable housing debt can have negative results, including the loss of the home through mort- gage foreclosure. A broad measure of home prices is given in Figure 9.1.

246 Part Three Portfolio Management


Ownership of real estate may take many forms. They include home ownership, real estate investment trusts, publicly owned real estate companies, private partnerships, and direct ownership of income-generating forms of real estate.

Real Estate Investment Trusts Real estate investment trusts (REITs) are publicly owned investment companies that invest exclusively in real estate and mortgages that are mostly traded on stock exchanges. They are free from business taxation provided they comply with certain regulations. A small number of REITs are privately held. They represent the grouping of individual real estate assets managed by one company. The assets held may have mixed uses, but the companies often specialize in one area, for example office buildings, apartment houses, or shopping centers. What makes a REIT different is its tax benefit. Regular corporations are “double taxed,” once when they earn money and again when their stockholders receive dividends from those earnings. REIT owners bypass corporate taxation and are taxed personally only on dividend payouts from the company. The government allows real estate companies to use the REIT form if they distribute at least 90 percent of their earnings each year. Consequently, REITs are high-payout, high-dividend yielding companies. They have become a significant force in real estate investments in recent decades. As an example, the largest public REIT, as of this writing, is Health Care REIT, which trades on the New York Stock Exchange under the ticker symbol HCN. This REIT owns retirement communities, skilled nursing facilities, medical office buildings, hospitals, and so on.

Traditional Publicly Owned Real Estate Companies Many real estate entities select a more traditional structure like other publicly owned com- panies. They often prefer the ability to reinvest their monies to build asset values instead of having to use the REIT’s high payout of earnings method.

Private Partnerships Private partnerships and private corporations are often established to purchase certain types of properties. The most common form is private partnerships, which offer indi- viduals part ownership in an investment structure that is not traded continually on a public exchange; they may be syndicated, that is, mass marketed to qualified individuals or

FIGURE 9.1 S&P/Case-Shiller U.S. National Home Price Index

Source: S&P Dow Jones Indices LLC https://us. spindices.com/indices/real- estate/sp-case-shiller-us- national-home-price-index.












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Chapter Nine Real Estate and Other Assets 247

formed by a small group of individuals. These partnerships may take the form of a general partnership in which one individual is in charge of operations and investors are limited partners, not part of day-to-day management, and have liability limited to the amount of their investment. Private partnerships have advantages and disadvantages. One disadvantage is its lack of liquidity. Often investors must wait until the property is sold to realize the cash proceeds from monies invested, and profits are typically returned many years later. One advantage for people prepared to wait is that private partnerships are thought to have higher projected returns than public ones to compensate for their liquidity risk. In addition, private partner- ships are not subject to daily fluctuations in price. The partnership may value its shares annually or not at all. For some people, the absence of short-term fluctuations forces them to focus on anticipated outcomes, which they find more reassuring than the volatility of prices in public markets.

Direct Ownership Direct real estate ownership is property belonging to a person or group without inter- mediaries operating and controlling it. Direct ownership is fairly common, particularly among individuals with high incomes. These individuals could be motivated by interest in any of a number of real estate types, which are described in the next section. One interest- ing combination is ownership of an entire small office or apartment building instead of renting space as a tenant; thus, the property is partially or fully occupied by a business or profession. For example, many dentists in individual practices own their own buildings, which often have proven to be an attractive investment over the longer term.


Many types of real estate are appropriate for investment. Some leading ones are described next.

Single-Family homes. Home ownership is for many part of the American dream. About two-thirds of Americans own their own home. Therefore, single-family dwellings can be attractive purchases for rental, income, and capital appreciation purposes.

Multifamily homes and townhouses. These dwellings are neither a single-family home nor an apartment building. Given that the external building structures are built to be shared by two or more families, the purchase price per square foot may be lower than for a single-family home.

Office buildings. These are commonly sources of investment. Rental income is received from individual occupants, and any boost in building operating costs due to inflation or for other reasons may automatically be passed along to the tenants, resulting in a rise in their monthly expense.

Individual stores and shopping centers. Rents may be on a monthly basis and can involve passing along increases in operating costs to the renter. The rental arrangement for shopping centers may provide the center’s owner a percentage of revenues from the sales in the stores or other participation in store profitability. The more people who pass the store and the area around it, the more sought after the property, and the higher the rental rate that can be charged.

Other. Storage facilities charge on the basis of location and size of the facility, which provides extra space for residences and businesses. Hotels are businesses in which owners can be the operators or can sublease the space to others.

248 Part Three Portfolio Management

Land. Land is technically not real estate but the ground underneath it. The price of the land depends on its location and the success of the companies or people who occupy the property on it. Raw land is often valued on its future potential to be developed.


Real estate ownership has many attractive features and a few that are less attractive. Its advantages and disadvantages are described next.


Significant Income Quality real estate such as properties that are rented or are under long- term lease often provide strong cash flows that result in significant income distribution.

Potential Growth Well-located and well-maintained real estate tends to appreciate over time. It is generally an integral part of both a successful business and a comfortable per- sonal lifestyle. As business and personal income increase so should the value of the space.

Solid Total Returns When income and growth in asset values are combined, substantial total returns are possible. In aggregate, unleveraged real estate may be viewed as possibly presenting long-term returns that are higher than bonds and lower than stocks. Borrowing to purchase real estate adds to a venture’s risk and its potential returns.

Lack of Correlation with Stocks The valuation of real estate typically is not correlated with stocks; therefore, real estate is an excellent diversification tool. However, publicly traded real estate companies such as REITs are influenced not only by real estate condi- tions but also by the movement in stocks overall.

Easy to Borrow Against Many businesses, particularly those not well established or highly profitable, may find taking on debt difficult. Real estate lending is generally avail- able for companies with good credit histories based on the market value of their property.

Inflation Hedge Real estate is often an excellent hedge against inflation. Office rentals of many types are principally made up of labor and materials, and higher outlays for them will be reflected in the prices of new construction. As with homes when prices rise for newer buildings, the value of existing properties tends to go up as well.

Tax Advantages Ownership of real estate provides many tax benefits. Real estate offers the opportunity to take depreciation as a deductible expenditure. Real estate gains that are taxable on sale can sometimes be postponed through a swap with another investment prop- erty. The significant tax advantages upon the sale of homes discussed previously are not available for sales of commercial real estate.


Liquidity Real estate generally takes significant time to sell, particularly when prices are weak. Any attempt to speed the process can result in a liquidity cost in the form of a lower sales price. As mentioned earlier, private partnerships generally require waiting until the sale of properties to return capital, which can take many years.

Involvement Direct real estate ownership is property belonging to a person or group without intermediaries operating and controlling it. Direct real estate investments are not like investing in publicly owned stocks but are more like operating a business. Without strong independent management, owners may be involved in the most basic operations.

Significant Transaction Fees The sale of a building can result in a brokerage transaction cost of 6 percent, a substantial portion of a year’s growth. Legal and accounting fees add to the cost.

Chapter Nine Real Estate and Other Assets 249

Decline in Attractiveness Changes in favored styles, need to keep lobbies updated, and installing wiring for current technological developments can make costly outlays neces- sary or risk declines in a property’s appeal.

Reduced Demand Due to Technology Technological developments are increasingly allowing people to work out of their homes. Video conferencing may result in a declining need for offices in which to conduct business with clients and co-workers, and online offerings can cause sales in brick-and-mortar stores to decrease. Reduced need for office buildings, hotels, stores, and shopping centers may result in reduced investment values.


Deciding on the value of a real estate property is often an inexact science. One reason for this is that, unlike mass-produced products, each piece of real estate is different and gener- ally isn’t movable. The three main methods for valuing real estate are comparable sales, replacement cost, and cash flow valuation. It is not uncommon for appraisers to use all three methods and take their average as the final valuation.

Comparable Sales Comparable sales involves examining the recent sales of similar properties to establish a specific property’s current value. Similar characteristics include location, size, exterior and interior quality, and style. This is used in most types of real estate and is the most popular method for valuing homes because earnings generally do not enter into consideration in owner-occupied homes.

Replacement Cost Replacement cost is the cost that would be incurred to rebuild a property that exists today. Estimating the cost to rebuild the property can be used to evaluate its current value. The valuation may be adjusted for the wear and tear on the existing structure.

Cash Flow Real estate cash flow is the actual cash generated from a real estate property’s operation. Cash flow is not its earnings, which are determined by accounting methods that make adjustments to cash flow. Accountants want a proper net income figure; real estate people want a pure cash figure so that they can value a building before items such as the amount of debt that is used to finance the building, which vary by owner, complicating the valua- tion process. Once they know the amount of pure cash flow, real estate people can make adjustments for different building items, such as total debt to determine what they would pay for the building.


Real estate companies or individuals are required to report their net income just like any other business operation. They have to make adjustments to reported earnings to arrive at cash flow. Together the cash flow is also known as earnings before interest, taxes, depre- ciation, and amortization (EBITDA). These companies or individuals do so by adding back selected items to the net income amount. An explanation of those items follows. In the next section, thereafter on the cap rate we use the cash flow generated that is called net operating income to learn how to value the building. Net operating income for real estate purposes can be defined as operating cash flow or earnings before interest, taxes, depreciation and amortization.

250 Part Three Portfolio Management

Exclusion of Interest and Tax In valuing a property, debt is often temporarily stripped from the calculation. Because the debt is treated separately, the interest on the debt is added back to net income for purposes of estimating the cash flow. Taxes on income for the building are affected by depreciation, interest, and other items. For this and other reasons, tax expense is also eliminated when valuing a property, thereby raising the cash flow.

Depreciation and Amortization Depreciation is a non cash charge that is supposed to reflect a decline in an asset’s value. However, well-maintained and well-located buildings do not lose allure and tend to move up in value over long periods of time. In other words, many buildings appreciate, not de- preciate. Despite that building owners are allowed to reduce their taxable earnings by a formulaic depreciation expense. Consequently depreciation can serve as a partial tax shel- ter against reported earnings. Therefore, depreciation is added back to net income to show an amount that is higher than net income. Amortization of building leaseholds, another noncash charge, is added back as well. Example 9.4 demonstrates how cash flow is gener- ated from net income figures.

Example 9.4 Ravi was examining the income statement of a public real estate company and as part of his analysis wanted to convert its earnings into cash flow. He had the following inputs: Net Income $123 Million, Interest $80 Million, Taxes $23 Million, Depreciation $65 Million, Amortization $10 Million

Cash Flow = EBITDA = 123 + 80 + 23 + 65 + 10 = $301 Million


This section will show you how to actually value real estate using its cash flow. The capi- talization rate (cap rate) is perhaps the most popular measure by which cash flow is used to value a property. The cap rate is the appropriate rate of return on a real estate investment as measured by dividing its cash flow by the buildings value. As discussed in the previous section, EBITDA reflects the desire to strip away nonoperating costs to obtain a building’s operating cash flow. A second definition for net operating income is all business operat- ing revenues less only those costs necessary for operating the building on a continuing basis. The cap rate is the required rate of return on the building. In theory, the cap rate starts with the market returns on bonds and usually adds a return premium required for the per- ceived higher risk of real estate. Therefore, when market interest rates on bonds rise the cap rate goes up. The higher the cap rate the higher is an investor’s required rate of return and the lower is the building’s value. More practically, the cap rate can be obtained by comparing a building’s sale price with its expected cash flow. The cap rate may be based on the current cash flow for the building or the projected cash flow after some normalization process. This process may include incorporating changes in the building’s appearance, a new marketing approach, or a return to normal occupancy rates that are currently affected by a weak economy or oversupply of space in a particular area. The need for an acceptable rate of return on a building in a geographical area brings oversupply back into balance just as high returns on existing real estate bring about new construction and new supply. The upshot is that markets for real estate tend to migrate toward normal supply and normal rates of return.

Chapter Nine Real Estate and Other Assets 251

The formula for establishing a building’s value is:

Building value = Net operating income 1EBITDA2

Cap rate

The formula for solving for the cap rate by transposing terms is:

Cap rate = Net operating income 1EBITDA2

Building value

The cap rate can be thought of as the cash yield received based on the property’s purchase price. After the purchase, the cap may be based on the property’s current value. As mentioned its pure cash flow or EBITDA is generally called net operating income. The cap rate over time is shown in Figure 9.2.

Example 9.5 Henry was interested in purchasing an office building. It had annual net income of $35,000, depreciation of $100,000, interest expense of $68,000 and taxes of $7,000. The building’s current owner wanted $1.8 million for the building that had $1.7 million of debt attached to it and that would continue after the purchase. Henry found out that other buildings of similar quality in terms of construction and location were selling at a cap rate of 6 percent and thought that with some modest changes, he could attract technology companies to the building. The outcome could be higher rental rates and an increase in the rating of the building to A, which would reduce the cap rate to 5 percent, thereby raising the value of the building. But first Henry wanted to know whether the price on the building as is was correct. Henry knew he had to eliminate depreciation, taxes, and interest to arrive at an operating figure. Because he was given a net earnings amount that had already deducted these items, he added them back He made a mental note that the net asking price of $1.8 million also had deducted $1.7 million in debt for which he would be liable. By adding the debt back in, he would arrive at the real asking price for the building. Then, using established real estate proce- dures, he could determine whether the asking price was appropriate. The calculation follows.

Building value = Net operating income 1EBITDA2

Cap rate

FIGURE 9.2 Real Estate Cap Rates 1990–2014

Source: NCREIF Trends Report 2014. Cap rate values are based on current value cap rates, market weighted.















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252 Part Three Portfolio Management

Net operating income = Net income + interest + taxes + depreciation = 35,000 + 2,800 + 7,000 + 100,000 = $210,000

Gross asking price of building = Net asking price + Value of debt on building = $1,800,000 + $1,700,000 = $3,500,000

Calculated value of building

V = $210,000

.06 = $3,500,000

Henry concluded that the asking price for the building agreed with what he believed its market value to be. It left room for him to make some modifications that would increase the building’s value and allow him to earn above average returns through higher yearly cash flows and realize a higher price when he sells the building.


Over the last several decades, the selection of assets for the average investor has grown. Hedgelike funds, including mergers and acquisition funds and long-short funds, have come into being through the mutual fund framework. The advent of exchange-traded funds (ETF), which are publicly traded groupings of stocks, bonds and other assets has broadened the use of indexes on all types of items including commodities, currencies, and alternative equity strategies, generally with the attempt to equal or exceed returns tradi- tionally available. The demand for new strategies meanwhile has increased as investors have become somewhat fearful of traditional investing as a result of the sharp decline in asset values in the 2008–2009 recession. Many investors are seeking alternatives, asking how they can protect themselves against a repeat of that portfolio plunge. It is not our purpose here to discuss the advantage and disadvantage of each investment alternative. Instead, we briefly discuss perhaps the two most popular alternatives: industrial and agricultural commodities and gold.

As mentioned, real estate in general and commercial buildings in particular are most often valued based on their cash flow. But there is another consider- ation called quality, which can be established by considering how well built and maintained the property is, how old it is, and how appealing is its style. Regardless of the type of real estate, never forget the importance of its location, which can be considered a big part of its quality. Generally attrac- tive locations command cap rates and sales prices

commensurate with the appeal of the real estate existing there. A strong location for real estate is somewhat like having a business that has a high market share in an attractive industry; it is hard to be dislodged. When real estate in excellent locations is depressed in cash flow and prices for reasons other than weakness in the building such as lack of mod- ern wiring, selecting that property over another in a less appealing location that is currently generating a somewhat higher cash flow could be advisable.

Professional Advice The Importance of Location

Chapter Nine Real Estate and Other Assets 253

Commodities A commodity is generally a basic good used in the business economy. Prices for com- modities (industrials such as oil and copper or agricultural products such as wheat, soy- beans, or livestock) reflect their own supply–demand schedules. The prices for industrial commodities often reflect the current stage in the economic cycle. Many commodities are traded on an international basis. They have been influenced by the increase in economic growth in less developed markets in Asia, Africa, and South America, which brings about higher commodity usage. The rise in commodity prices among the natural resource- producing countries in various parts of the world has created wealth used to purchase a higher standard of living. Populous countries, particularly China and India, whose economies have been growing at above average rates, may continue to influence commodity prices. The rise in commodity prices and labor costs are two principal creators of inflation. Many investors in commodities are seeking a hedge against inflation. Inflation signifi- cantly hurts most bonds and, for a time, stocks. This most popular way to invest in com- modities may be through mutual funds or exchange traded funds (ETF). They offer investments in commodity-influenced stocks or commodity indexes that directly benefit from commodity price rises.

Gold Gold, the best known precious metal,6 as a great deal of mystique that comes from the allure of precious metals and the fact that it was used by countries for many years to directly support paper currencies used in trade. That direct link has been terminated, but the appeal remains. Gold often does well when individual countries or the world is in turmoil. At that time, individuals may seek an alternative to paper currencies. For example, gold performed bet- ter than stocks in the periods leading up to and following the severe 2008–2009 recession. Gold can also appreciate in times of high inflation as investors seek something “stable” that can keep up with the rising cost of living. In aggregate, gold can be viewed as a hedge against traditional stock and bond invest- ments. It is one of a very few items that is negatively correlated with the performance of financial investments. Mutual funds offer investments in gold stocks, and some ETFs offer the ability to invest directly in the commodity itself. See Figure 9.3 for gold prices from 1970–2014.

6 Gold can be viewed as a commodity. However, our definition of commodity for this book’s purpose is a basic good used in business production. Gold is principally a store of value and therefore is best regarded as a precious metal.

FIGURE 9.3 Gold Prices, 1970–2014

Source: Based on World Gold Council, Interactive Gold Market Charting, LMBA, Datastream, BullionDesk/FastMarkets, http:// www.gold.org/

–500 USD


500 USD

1,000 USD

1,500 USD

2,000 USD

1980 1990 2000 2010

254 Part Three Portfolio Management

College Age • Nothing needed yet, but if you are the type, you can “practice” with real estate by leasing a home and renting it out to several other college kids at a suitable markup in cost.

Twenties • Take your time. Wait until you have a city and a job you like and often a suitable partner before considering a home purchase. If it isn’t now, the correct time, it will come.

• If it is your style, purchase a home that needs improvement, preferably in a good neighbor- hood. Live in it while you fix it up and then sell it. The result can potentially be tax-free profits that on an after-tax basis exceed what you earn in your day job.

Thirties • If you haven’t done so yet, at least think about purchasing a home now. The tax benefits, forced savings features, normal growth, and inflationary participating characteristics as well as potential for it to broaden your investment portfolio are reasons to give the home serious consideration.

Forties • Think about the relative benefits of improvement of your current home versus purchasing a larger one.

• If home purchase is not your thing, contemplate purchase of REIT funds or other real estate vehicles.

Fifties • Consider purchasing a second home and renting it out or even purchase of a business building perhaps with people you know and trust.

Sixties • This may probably be the time to add some inflation hedge characteristics such as com- modities or gold funds.

Seventies and Beyond • Your home is a significant hedge against living an extra long life or unexpected setbacks in income or health. Hold it for sale and subsequent downsizing or rent, should it prove expeditious to do so.

Life Cycle Planning Real Estate and Other Assets

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Chapter Nine Real Estate and Other Assets 255

The rapid growth of ETFs in particular has both responded to and created an interest in commodities and precious methods such as gold. Investors should be wary of treating them as normal investments. Traditional investments, such as stocks, bonds, real estate, and private businesses, provide income and can grow substantially in value over time. For many investments, the current cash payout of profits and promise of growth in its value sets their price. Commodities and gold are not businesses; they don’t provide income or cash payout. They, like many other alternative assets such as art, antiques, and other collectibles, are priced by demand and supply. When consumer tastes shift and demand weakens temporarily or permanently, prices can fall sharply. Consider, for example, the demand and

price for baseball cards or comics, which has dropped precipitously in recent years. Commodities have some underlying usage, and gold has a long-standing sense of worth, but both gold and oil among others have had prices respond to fickle consumer preferences that have resulted in losses for investors. Investors should be very careful about straying be- yond traditional investments. Commodities and gold should be considered principally as investments that have low or negative correlation with stocks and bonds and employed as a safety hedge against inflation; gold may also protect against economic uncertainty. In other words, these asset classes should be used as a hedge to help alter the risk profile of a portfolio, not to provide high projected long-term growth on the cash invested.

Professional Advice Other Assets

Back to Dan and Laura REAL ESTATE AND OTHER ASSETS When Dan and Laura sat down, I knew something was up. Laura had a smile on her face and Dan had a frown. Laura said, “Congratulate us; I’m pregnant again.” After Dan and I managed a quick smile, he indicated his concern. Basically, he wondered if he could afford to have two children. He said that they would have to move almost immediately because their apartment was too small for two children. He wondered if they would be bet- ter off renting a home. They expected to live in a house for seven years and then sell it if they owned it or end the rental lease and move to a home closer to Laura’s job, which would also cost about what the original house had. Both agreed that the cost of a home would be about $250,000 to buy and $15,000 a year to rent. I thought to myself that this may be only one additional child, but it is a whole new ball- game as far as near-term planning is concerned. The main area we would have to work on was a home.

Here’s how I replied to their questions: Let’s go over the purchase of a home. There is no choice as to whether to move when a family situation dictates that a move must take place. Given Laura’s pregnancy, it must happen fairly soon. You’ve asked whether it would be better to buy or rent. Based on the figures supplied regarding $250,000 to buy or $15,000 to rent annually, I’ve calculated an after-tax rate of return. I’ve assumed that the house would increase in value by the pro- jected rate of inflation, 3 percent a year. I recommend the purchase of a home, not the rental. The tax benefits available through deductibility of interest and real estate taxes plus the ability to sell your home without pay- ing any tax (for a married couple the first $500,000 of gain is tax free) can make it a highly profitable investment. Our projected return is 19 percent after tax.

256 Part Three Portfolio Management

Buy versus Rent


Rental expense $15,000 Cost of house $250,000 Down payment $12,500 Mortgage $237,500 Interest rate 7.25% Mortgage term (years) 30 Marginal federal tax rate 25.0% Marginal local tax rate* 3.8% Federal/state marginal tax rate 28.8% Inflation rate 3.0% Property taxes $2,500 Upkeep and insurance $3,000 Private mortgage insurance (PMI) $1,200

2016 2017 2018 2019 2020 2021 2022

Down payment $12,500 Beginning principal $237,500 $235,399 $232,943 $230,303 $227,465 $224,414 $221,134 Mortgage payment 19,442 19,442 19,442 19,442 19,442 19,442 19,442 Interest paid 17,143 16,971 16,786 16,587 16,373 16,143 15,895 Principal paid 2,299 2,471 2,656 2,855 3,069 3,299 3,547 Mortgage outstanding $235,399 $232,943 $230,303 $227,465 $224,414 $221,134 $217,609

Cash Flow

Outflows Down payment ($12,500) $0 $0 $0 $0 $0 $0 Mortgage payment (19,442) (19,442) (19,442) (19,442) (19,442) (19,442) (19,442) Interest payment (17,143) (16,971) (16,786) (16,587) (16,373) (16,143) (15,895) Principal payment (2,299) (2,471) (2,656) (2,855) (3,069) (3,299) (3,547) Property taxes (2,500) (2,575) (2,652) (2,732) (2,814) (2,898) (2,985) Upkeep and insurance (3,000) (3,090) (3,183) (3,278) (3,377) (3,478) (3,582) PMI 1,200 1,200 1,200 1,200 1,200 1,200 1,200 Balloon payment (217,609)

Total ($36,242) ($23,907) ($24,077) ($24,252) ($24,432) ($24,618) ($242,418)

Inflows Tax deductions $5,669 $5,625 $5,578 $5,528 $5,473 $5,415 $5,353 Proceeds from sale of home


Total $5,669 $5,625 $5,578 $5,528 $5,473 $5,415 $288,940

Net Cash Flow ($30,573) ($18,282) ($18,499) ($18,724) ($18,959) ($19,203) $46,522 Rent not paid $15,000 $15,450 $15,914 $16,391 $16,883 $17,389 $17,911 Effective bottom line ($15,573) ($2,832) ($2,585) ($2,333) ($2,077) ($1,814) $64,433

IRR 19%

* Based on 5 percent state rate deductible on federal return.

Chapter Nine Real Estate and Other Assets 257

College Student Case Study and Review: Amy and John REAL ESTATE AND OTHER ASSETS The idea of buying a home captured the attention of Amy and John, but owning income- producing real estate and miscellaneous assets held little interest for Amy. I started by mentioning that real estate is the most valuable asset that many people have. The home is by far their most important piece of real estate. It has a number of features that distinguish it from most durable goods:

1. Unique physical characteristics.

2. Long lasting

3. Tax benefits.

4. Potential to rise in value.

5. Fixed location.

6. Situated on land.

Its uses include:

1. Providing shelter.

2. Being a long-term investment.

3. Giving pleasure to its occupants.

The ability to obtain a mortgage, if they are working and responsible, enables people to buy a home with only a 20 percent down payment rather than having to wait until they have saved the full price. Owning a home presents tax benefits including no tax on the first $250,000 of gains reached for an individual or $500,000 per couple. Also, interest on a home mortgage and property taxes are tax deductible.

The return on a home for a period

= Increase in home value + Rent not paid − Cost of upkeep

Market value of house, beginning of period

Factors in owning a home are:

Current income The higher the income, the higher is the amount to spend if desired.

Tax bracket The higher the tax bracket for income, the lower is the net cost of mortgage debt and real estate taxes.

Liquid assets and debt Liquid assets make it easier to access a down payment. Debt owed already can limit the amount of mortgage debt allowed.

Affordability As a general rule, pay less than 28 percent of your total income.

Price The further from business areas, the lower the cost of the home generally is.

The buy versus lease (rent) information regarding a home can be calculated. It is strongly influenced by the price of home versus the rental and the cost of debt. Therefore, the one that is cheaper can vary over time.

Advantages of home ownership Tax benefits, inflation hedge, good return on investment.

258 Part Three Portfolio Management

Disadvantages of home ownership Possible using up of liquid funds on purchase, responsibility for care of property to sell quickly if needed, vulnerability to short-term cyclical changes in home price.

Other Forms of Real Estate Characteristics

REITs Public or private, required to pay out at least 90 percent of profits to avoid double taxation of gains; high payout with lower growth but above average dividend yield.

Private partnerships Not publically traded or liquid, possible higher return over the long term.

Direct ownership Investor responsible for supervision of property. Advantages of real estate ownership Significant income, potential growth of assets,

solid total returns, lack of correlation with stocks, easy to borrow against, inflation hedge, tax advantages.

Disadvantages of real estate ownership Ties up liquid funds, significant transaction fees, vulnerability to changes in location pref- erences, cost of upkeep

These are three ways that real estate is usually valued. Appraisers may blend all of the methods to arrive at their value.

Comparable sales The recent sales price of similar properties.

Replacement cost The cost to rebuild the property. Cash flow valuation The property’s returns in cash: Depreciation treated as a noncash charge. Debt and interest often excluded in arriving at


The most popular form of valuation is the CAP rate

Building Value

Cap rate = Net operating income 1EBITDA2

Building value

EBITDA = Earnings before interest, taxes, depreciation, and amorization

Other Assets Other assets as an alternative—or more usually as a supplement to stocks and bonds—have grown in popularity. Commodities such as those used in industry are being invested in more often. Gold has gained in popularity. It is used particularly in times of worldwide uncertainty and when inflation has increased sharply.

Summary Real estate and commodities make up an important section of an overall portfolio, provid- ing diversity of assets from stocks and bonds. Understanding the advantages and disadvan- tages of different types of real estate is critical in order to build an appropriate portfolio.

• Home ownership is an asset with unique characteristics. It often presents advantages over renting because of its tax benefits.

Chapter Nine Real Estate and Other Assets 259

• Valuation of a real estate property is often an inexact science. One reason for this is that, unlike mass-produced products, each piece of real estate is different and generally cannot be moved to suit the purchaser. There are three main methods for valuing real estate: comparable sales, replacement cost, and earnings valuation. It is not uncommon for appraisers to use all three methods and take their average as the final valuation.

• Commodities such as agricultural products/industrials and gold reflect their own supply–demand schedules or the current part of the economic cycle. Many commodities are traded on an international basis. Populous countries, particularly China and India, whose economies have been growing at above average rates may continue to influence commodity prices.

• This most popular way to invest in commodities may be through mutual funds or ETFs. They offer investments in commodity-influenced stocks or commodity indexes that directly benefit when commodity prices rise.

Key Terms cap rate, 250 commodity, 253 comparable sales, 249 depreciation, 250 direct real estate ownership, 247

exchange-traded funds (ETF), 252 gold, 253 net operating income, 249, 250 private partnership, 246

real estate investment trusts (REITs), 246 replacement cost, 249

ncreif.org National Council of Real Estate Fiduciaries NCREIF serves as a collector, validator, and disseminator of real estate performance information. It produces several quarterly indexes that show real estate performance returns. This site is a useful resource for obtaining real estate investment data.

gold.org World Gold Council This is the market development organization of the gold industry. The site contains extensive information regarding all aspects of gold from mining and manufacturing to investing.

cmegroup.com Chicago Mercantile Exchange This is the world’s largest futures exchange company and where all commodities are traded. This site can be very useful for evaluating how the market prices future com- modities or for investing directly in commodity futures.


Questions 1. Why do people purchase a home? 2. Is the home likely to be a good investment? Explain.

3. What are the significant characteristics of a mortgage?

4. Why is the home often a better investment than renting? Under what circumstances would renting be preferred?

5. Why is a home a good inflation hedge? Should a home be included as an asset if its occupants aren’t sure they could sell it? Explain.

260 Part Three Portfolio Management

6. Compare and contrast the value in owning a home versus investing in real estate investment trusts (REITs).

7. In what cause would you to suggest direct ownership over private partnership? Why?

8. If you had to select one method of valuation for real estate, which would it be? Why?

9. What is involved in establishing the cap rate?

10. What is the cap rate’s significance in terms of real estate?

11. What do commodities protect against? What is the downside to commodity investment?

12. Why is investing in gold appealing?

13. How should exchange traded funds (ETF) and other commodities be treated from an investment standpoint? What is their main value? Explain.

Problems Jack purchases a house for $90,000 and spends $15,000 to renovate it. He holds the house for 35 years and then sells it in middle of a real estate bubble for $400,000. On how much of that amount does he have to pay taxes?

Mary purchased a home for $200,000. By living in the home, she saved $18,000 annually because she did not have to pay rent. She had to pay $3000 annually for upkeep of the home. By the end of the first year, the home price had appreciated to $210,000. What was her return for the first year (considering assumed rents)?

Josh earns $80,000 a year. He would like to purchase a home and applies for a mortgage from the bank. The bank requires that the debt not exceed 28 percent of his annual income. With the current down payment he is willing to pay, his monthly mortgage payment will be $1,600. In addition, he will have to pay $4,000 annually for tax and insurance. Will the bank approve his loan?

Harry decides to purchase an apartment building as an investment. He pays $6,000,000 for the building. The building has a net income of $150,000, annual depreciation $150,000, annual taxes of $75,000, and annual interest payments of $105,000.

a. Calculate the building’s cap rate.

b. One year later, the price of the building goes up to $7,000,000. Calculate the new cap rate.





Chapter Nine Real Estate and Other Assets 261

Case Application REAL ESTATE AND OTHER ASSETS Monica continued to worry about the couple’s financial future. She began to question their investment in a home. She asked whether would be better to sell their home now and invest the proceeds. She estimated that the marketable securities would provide a return of 5 percent after taxes. She and Richard thought the current value of the house now would be $300,000 and would increase by 6 percent a year. A rental in a comparable apartment would cost $2,200 a month. Assume for purposes of this section only that Richard and Monica’s marginal tax bracket is 30 percent and other statistics including:

Annual maintenance $3,000 Property taxes $5,000 Insurance $1,500

Case Application Questions 1. Calculate the projected return on the house for the next year and give your recommendation.

2. Finish the nonfinancial investments section of this case, which includes the topics described in the previous chapter and this one.

Appendix I

Buy versus Lease—Home The example of buying versus leasing that follows uses the “Analysis of Rent versus Own” Practical Comment in the chapter.

Example 9.A1.1 Frederick and Dorothy, who have two children, were interested in moving from an apartment to a house. They didn’t know whether to buy a house or rent it. They found a house they liked that would require a $200,000 expenditure including closing costs. There was a house for rent on the same block that was almost identical to the one they were considering and had a rental cost of $2,000 per month. The rental contract stated that the renter would pay all normal main- tenance costs inside and outside the house, but the owner would pay for repairs, maintenance, and improvements designed to maintain the value of the property in real terms, estimated to be worth $3,000 per year: property taxes totaling $4,000 per year and insurance on the house for $1,000 per year. Except for these items, Frederick and Dorothy assumed that the costs for rent- ing and buying would be the same and therefore need not be included in a comparison. To simplify this problem, assume that there is an interest-only loan; therefore, no payments of debt would be required until the mortgage falls due. Furthermore, assume that it would be a 10-year fixed-rate mortgage for 80 percent of the value of the property at a 7 percent interest rate. Assume that Frederick and Dorothy are in the 35 percent marginal tax bracket and have a 5 percent risk-adjusted after-tax rate of return on alternative investments. In addition, assume that the value of the house they are considering for purchase would increase at the projected inflation rate of 3 percent per year, that all costs other than interest would rise at 3 percent, and that costs with the exception of the down payment would be paid all at once at the end of each period. Finally, assume that if they buy the house, they will sell it themselves at its market value in seven years. Should they buy or rent?

262 Part Three Portfolio Management

Return on house = Proceeds from sale + Ownership operating advantage Mortgage = 80% of purchase price

= 0.8 × 200,000 = $160,000

Down payment = $200,000 − $160,000 = $40,000

Yearly rental cost = 12 × 2,000 = $24,000

Home Buy versus Lease

Inputs Explanation

Purchase price $200,000 80% of purchase price Mortgage $160,000 Purchase price − Down payment Down payment $40,000 Monthly rental cost $2,000 Yearly rental cost $24,000 2,000 × 12 months Mortgage interest rate 7% Required rate of return 5% Inflation rate 3% Marginal tax bracket 35% Holding period (in years) 7

Value of House in 7 Years

Selling price $245,975 Capital gain from the sale $45,975 Selling price − Purchase price

Ownership Costs

Yearly Costs Pretax

After Tax without Interest

After Tax with Interest Rental Costs

Ownership Operating Advantage Explanation

Interest $11,200 $7,280 Pretax = 160,000 × 7% After tax = Pretax (1-0.35)

Opportunity cost* $2,000 Opportunity cost = Down payment × Investment return = 40,000 × 0.05 After tax = 4,000 × (1-0.35)

Real estate taxes $4,000 $2,600 Insurance $1,000 $1,000 Repairs and maintenance

$3,000 $3,000

Total yearly costs




Yearly after-tax costs = After-tax interest + Total after-tax costs

Year Down Payment

1 $40,000 $8,600 $15,880 $24,000 ($31,880)† Rental costs − Ownership costs (includes down payment cost)

2 $8,858 $16,138 $24,720 $8,582 3 $9,124 $16,404 $25,462 $9,058 4 $9,397 $16,677 $26,225 $9,958 After-tax costs excluding interest

grow 3% a year 5 $9,679 $16,959 $27,012 $10,053 6 $9,970 $17,250 $27,823 $10,573 7 $10,269 $17,549 $28,657 $57,083 Plus capital gain from the sale

* See Chapter 4 under the cost of time for a more detailed explanation of opportunity costs. In a related area, opportunity cost can be defined as the amount of money that can be made on an alternative use for an item. In this case, it is investing the down payment in financial assets. † This assumes for simplification purposes that all interest and rent payments occur at the same time as the down payment. The actual payment on average would be made at about the middle of the year, which would modestly reduce the internal rate of return (IRR).

Chapter Nine Real Estate and Other Assets 263

General Calculator Approach HP12C TI BA II Plus

Clear the register f FIN


2nd CLR Work Enter cash initial outflow 31,880 CHS g CFo 31,880 +/− ENTER ↓ Enter cash inflow Year 2 8,582 g CFj 8,582 ENTER ↓ ↓ Enter cash inflow Year 3 9,058 g CFj 9,058 ENTER ↓ ↓ Enter cash inflow Year 4 9,548 g CFj 9,548 ENTER ↓ ↓ Enter cash inflow Year 5 10,053 g CFj 10,053 ENTER ↓ ↓ Enter cash inflow Year 6 10,573 g CFj 10,573 ENTER ↓ ↓ Enter cash inflow Year 7 57,083 g CFj 57,083 ENTER ↓ ↓ Calculate the internal rate of return f IRR IRR CPT

33% 33%

Calculator Solution

Value of home in seven years:

Inputs: 7 3 –200,000

Solution: 245,975


Rate of return = 33%

At the end of year 7, close out the loan and resell the house.

Press FV = $245,975 Less purchase price of $200,000 yields pretax gain:

$245,975 − $200,000 = 45,975

According to current tax law, up to $500,000 of the couple’s gain could be excluded if they sold or exchanged their main home and they have owned it for more than two years. So there is no tax on the capital gain of $45,975. Determine the IRR of cash flows from ownership operating advantage in years 1 to 7 plus the gain on sale of the home in year 7 or (11,108 + 45,975) in year 7.

Because 33 percent substantially exceeds the comparable after-tax rate of return available for other investment alternatives (5 percent), the home should be purchased.


Chapter Goals

This chapter will enable you to:

• Apply risk and return principles to investments.

• Develop an overall asset allocation.

• Learn how to actually select individual mutual funds.

• Evaluate the factors that enter into investing in financial assets.

• Relate financial investing to overall household operations.

• Recognize how portfolio management differs from individual asset selection.

• Distinguish among investment alternatives.

• Utilize leading ways of measuring investment risk.

Dan and Laura had a special interest in small companies, biotechnology, and investing in China. However, their investment tolerances for risk were far apart, with Laura more inter- ested in stocks and having a much higher tolerance for risk. Constructing an investment portfolio for them looked as though it was going to be difficult.

Real-Life Planning

One of the themes underlying this chapter is the principle of risk and return. That is, risk and return are related and, generally, the higher the return people expect to receive on an invest- ment over time, the higher the risk they accept. People who may measure performance by only one of those variables—return—can overlook this principle. When people consider buying a risky investment, they should anticipate purchasing an asset with a larger projected gain to compensate for the possibility of loss. Many people say they don’t understand why so much time is spent on measuring risk. The following example may help you understand this. There was a mutual fund manager who developed a reputation for above-average per- formance purchasing U.S. government bonds. Bonds are considered more conservative and more stable than stocks. There are no bonds more “plain vanilla” than U.S. govern- ment issues because Treasury bonds are perceived as having no risk of nonpayment. Some people would say that the only way to invest in something that would outperform them is to be able to predict interest rates consistently. If there is anyone with that predictive abil- ity over extended periods of time, he or she hasn’t publicly demonstrated it. Thus, it was all the more surprising that this manager of mutual funds rather consistently invested in products that had high market returns. When asked whether he was taking risk in his active management approach, he said he wasn’t. His first priority was the safety of his investors’ principal and using primarily U.S. government bonds helped him achieve it. He had

Chapter Ten

Financial Investments

Chapter Ten Financial Investments 265

developed a growing following among individual investors, financial planners, and investment managers who were all attracted to his high returns and his firm answers to their questions. Then one day Federal Reserve action raised interest rates sharply, which surprised vir- tually all investors in the bond market. The increase in rates had a major negative effect on bond managers who were using derivatives, a financial instrument sometimes employed to enhance returns. This manager’s funds declined by more than 25 percent, which, in the world of high-quality bond funds, happens less often than losing more than three-quarters of investors’ money in stock funds. A fundamental analysis of his style would have uncov- ered his heavy utilization of derivatives, which changed the bond price volatility and there- fore the profile of the fund. However, there was a much simpler way to identify the higher risk he had undertaken. His standard deviation, the measure of risk represented by fluctuations in his returns over time, was much higher than that for any other fund in this category. It suggested that under certain negative circumstances, he could have problems. This information was available in an easy-to-understand format accessible in many public libraries. In other words, analysis of risk and return could have prevented the loss that many investors of his clients experienced.


Why do people make investments? They typically don’t save money because they like investing as a leisure activity. Instead, investments are the result of a person’s decision to spend less today so that he or she will have enough for future spending needs. For exam- ple, one major reason for saving and investing is to have enough money to live comfort- ably in retirement when there is no longer active work-related income. How much people set aside for investments depends on their goals, which are strongly influenced by the pleasure they have from spending today versus their satisfaction from saving monies so that they can live the good life in the future. Chapter 8 explained that investments can be separated into financial and nonfinancial ones. Frequently, nonfinancial investments such as a person’s home and its possessions and his or her career and other human-related benefits are connected to household func- tions today. Many such investments fall under the umbrella of capital expenditures. On the other hand, financial investments such as stocks, bonds, and mutual funds tend to be reserved for future household use.1 Ownership of these assets is evidenced by pieces of paper instead of real assets that can be touched. In contrast to many nonfinancial assets, financial ones have little or no real cost of upkeep and often provide income and maintain or increase their value over time. For example, a financial asset such as a quality stock often provides dividend income and increase in price over time. In contrast, a nonfinancial real asset such as a washing machine or car has no cash income directly, requires upkeep, and tends to decline in value over time.2

Traditionally, investment theory and, to a large extent, investment practice tend to focus on financial assets, which are generally assumed to have readily available market prices. In this chapter, which concentrates on financial assets, we assume that all assets discussed are marketable and are called marketable securities. Analyses of these marketable investments are facilitated because their values are objectively determined, competitively established, and easily measured. It’s relatively simple to go online, for instance, and find the current price of a given stock or of a mutual fund holding many stocks.

1 However, during retirement, they are employed to fund current household functions and, in some cases, the investments or, more frequently, the income from those investments is used currently. 2 A house is a partial exception. If well maintained, it may rise in price for many years before it begins to decline.

266 Part Three Portfolio Management

Given the focus on financial assets, when we discuss risk, we concentrate on invest- ment risk. Investment risk is the risk principally associated with savings placed in fi- nancial assets—the chance of a decline in asset value, typically measured by its market price. Investment risk is in contrast to insurance risk, which is primarily associated with possible deterioration in usability or valuation of a household’s nonfinancial real or human assets. Insurance risk can be reduced or eliminated by transferring it to an insurance company. The analysis of household operations must, of course, incorporate both risks. In this chapter, we view investments and asset allocation from a financial planning per- spective. We describe the entire asset allocation process as an advisor would, beginning

FIGURE 10.1 The Planning System for Asset Allocation

Establish Goals

Consider Personal Factors

Include Capital Market Factors

Identify and Review Investment Alternatives

Employ Portfolio Management Principles

Formulate Asset Allocation Decisions

Evaluate Specific Investment Considerations

Select Individual Assets

Finalize and Implement Portfolio

Review and Update the Portfolio

Chapter Ten Financial Investments 267

with goals and ending with portfolio management implementation. With this knowledge, you should be able to establish an overall asset allocation, one that can improve your investment performance. Asset allocation for financial investments refers to the amount and type of securities that they place their money into. The financial instruments used are typically stocks and bonds or mutual funds. The exact breakdown by category and further separation into sub- category can vary depending on the person. For example, one person may have 100 percent of an investment portfolio in large company stocks whereas another may have 60 percent in stocks and 40 percent in bonds with holdings that include stocks of all sizes and invest- ment styles as well as many types of bonds. The planning system for asset allocation has eight components, which are given in Figure 10.1. We will examine each of them.


Goals are at the head of the financial planning process. They were discussed in detail in Chapter 3. Goals are, of course, determined by our needs and the things and activities that we enjoy. Common goals are becoming financially independent, saving for a major capital outlay such as a car, and putting away money for a child’s college education. A comfort- able lifestyle in retirement is often a key goal in personal financial planning. Once we have established our goals, we are in position to identify the role savings and investments play in the process. Investments can be viewed as a delivery mechanism: They help create sufficient assets to fund our goals. Our financial planning procedures can establish the amount of money needed for each goal. More narrowly, our investment focus is on the  appropriate asset allocation to help meet our goals.


An asset allocation in practice is not a rigid representation of market factors alone. It is also influenced by personal characteristics. The factors discussed here are some of the personal considerations that enter into the asset allocation process.

Time Horizon for Investments We have many goals. They tend to vary in their horizon—that is, the time frame we have set to achieve our goals. Time frames are important because most investments fluctuate in value. It would be improper to place volatile stocks in an investment account due to be liquidated in three months; the risk of loss should the market decline would be too high. Similarly, for most people, it would be a mistake to place a person’s entire investment sum in a money market account when the monies will not be needed for 20 years; the after-tax returns could trail the cost of living and instead of an increase in investable sums, the amount accumulated could decline on an inflation-adjusted basis. We can group goals for investment purposes into five time horizons (see Table 10.1).

Liquidity Needs Liquidity in an investment framework is the need or desire to be able to convert assets into cash. The need can come from a planned expenditure to be made at a fixed future period. In that case, it is covered under the time horizon just discussed. Alternatively, liquidity can be needed for current income to fund living expenses. It also can be a function of risk preference, employed for emergency use to reduce risk in general because typically the more liquid the financial instrument, the lower the risk of investment loss. Investments

268 Part Three Portfolio Management

vary in their degree of liquidity. For example, well-known large-size issues such as U.S. government bonds are generally more liquid than small local hospital obligations, and publicly traded securities tend to be more liquid than private partnerships.

Current Available Resources The investments we select are influenced by the amount that we have accumulated in financial assets. In addition, other resources such as real estate and human assets affect our asset allocation. This thinking is, of course, part of total portfolio management (TPM). Simply put, under TPM, our asset allocation is affected by the amount and risk character- istics of all our assets.

Projected Future Cash Flows Projected future cash flows are obtained by subtracting anticipated outlays from revenue streams. We have called that difference net cash flow, the amount that we are free to employ in any way we wish. The higher our projected net cash flows and the lower their risk of a disappointing outcome for it, the more able we are to handle a risky investment. That is so because we have future monies to invest that will offset disappointing results from our current assets.

Taxes Our tax brackets vary. Investment decisions should be made based on our after-tax returns. Therefore, our asset allocations can vary depending on our marginal tax bracket. For example, those of us in low tax brackets use taxable bonds whereas those in high ones often own tax-free municipal bonds. When changes in portfolio assets are contem- plated, the impact of gains or losses on sale must be included in the calculation of return. For example, there is little purpose in selling a well-regarded stock to take advantage of a potential extra 10 percent price gain on another security purchased with the proceeds from sale of the well-regarded issue when the sale will result in a 20 percent federal and state tax payment from the gain on liquidation of the original stock bought at a very low price.

Restrictions Restrictions in formulating an asset allocation are limitations on freedom of choice for investment alternatives or investment practices. Many restrictions are included under the other items discussed—for example, not using municipal bonds for people in low tax brackets.

TABLE 10.1 Time Horizons

Time Frame Horizon (years) Examples of Goals Investment Policy

Immediate 0 Emergency fund and other Money market funds possible uses within days or weeks Short term 0–2 Vacation, new car U.S. government bonds, certificates of deposit, short-term bond funds Intermediate term 2–4 Down payment for home, Conservative stocks, renovation of home mutual funds, bonds Long term 4–10 Education for a child Normal long-term asset allocation Very long term More than 10 Retirement Normal long-term asset allocation

Chapter Ten Financial Investments 269

In addition, they may restrict the use of debt to finance purchase of investments or preclude the use of higher-risk options or commodities. Finally, individuals may have specific prefer- ences; for example, there are those who prefer funds promoted as being socially responsible by avoiding investments in tobacco companies.

Risk Tolerance Risk tolerance is the amount of risk a person is willing to accept. Some people think of it solely as a function of one’s personality. However, it can be influenced by many vari- ables in addition to personality including upbringing, current circumstances, family concerns, the amount and type of the household’s current assets, and expected future cash flows. A person’s risk tolerance can be determined in many different ways. People can be asked to describe themselves and their tolerance for risk. For example, the question may be framed as “In investment matters, do you consider yourself conservative, moderate, or aggressive?” Alternatively, their prior actions can be observed. For example, looking at a breakdown of their current portfolio can help determine the appropriate asset

A number of other factors concerning human char- acteristics should be considered.

SELF EVALUATION When a self-evaluation approach to risk tolerence is used, risk assessment should be carefully related to types of investments. What one person thinks is conservative, another may think is aggressive. For example, some people, perhaps influenced by their personal experience of long-term appreciation of their home, regard both public and private real estate, like bonds, as less risky whereas others recog- nize that real estate risk is more closely related to equity investments. Also, self-assessment of risk tolerance and many other assessment techniques can reflect cyclical variations in tolerance for risk. Put simply, people’s

expressed tolerance for risk often tends to rise when prior overall market performance has been good and when the outlook for investment returns appears very favorable. The opposite is true when past results and the outlook are poor. Unfortunately, the latter can be the wrong time to change asset allocations. Financial planners should discourage changes for these reasons, pointing out that the outcome of making changes has resulted in poor performance. For example, when suspecting a rise in risk tolerance because of strong recent market performance, clients should be told to visualize how they would feel about a change in risk if the market were in the midst of a decline. In general, it is advis- able to stress a fixed tolerance for risk over a long- term time frame.

Professional Advice Adjustments to Risk Tolerance

Asset allocations can be influenced by past personal experiences that may not be entirely logical. A client may not want to purchase a particular type of security—say, a mutual fund offering small-size companies—because she was “burned” in that type

of security in the past. The planner can stress the benefits of investing in that asset class, but if the  client is adamant, another type of security with  many of the same characteristics should be substituted.

Professional Advice Past Experiences

270 Part Three Portfolio Management

allocation for them. Another approach is to give them a variety of oral or written ques- tions that can be scored to help determine their risk tolerance. One such questionnaire is given in Table 10.2.


We’ve established the goals and some distinguishing features of individuals. At the same time, we need to examine the characteristics of the overall financial markets and of the various types of securities likely to be considered for the asset allocation. We begin by discussing two of the most basic characteristics of finance: risk and return.

Risk and Return One of the most logical thoughts in investing is that risk and return should be related. If we select an investment that has a higher degree of risk, we expect to earn a higher

Answer the following questions using ratings from 1 (strongly agree) to 5 (strongly disagree).

1. Short-term fluctuations in the value of my assets do not bother me. 2. I tend to buy and sell securities at the right time. 3. Having high current investment income is not important to me. 4. If an investment could not be sold quickly without a substantial financial penalty, it would not disturb me, provided the

longer-term returns on the investment were favorable. 5. It would not bother me at all if I couldn’t sell my new investment for many years if there was the potential for unusually

good performance. 6. Investing in common stocks and common-stock mutual funds does not make me jittery. 7. I am willing to endure a significant decline in my principal over a few years if it will result in higher longer-term returns. 8. I am willing to take on higher risk so that I can obtain a hedge against inflation. 9. I don’t need a guaranteed return of my principal if forgoing that will greatly increase the potential longer-term growth rate

of my investments. 10. If the prevailing economic and investment sentiment seemed gloomy, I would not switch to safer securities.


Risk taker Below 20 Middle of the road 20–40 Conservative 40 or higher

TABLE 10.2 Risk Profile Quiz

Source: Lewis Altfest and Karen Altfest, Lew Altfest Answers Almost All Your Questions about Money (New York: McGraw-Hill, 1992), p. 64.

Individuals have been known to profess an exag- gerated amount of risk tolerance. In the bull market of 2003–2007, investors generally called themselves moderate or aggressive in terms of risk tolerance and thus invested considerable amounts in equities. When stocks crashed in 2008, however, a number of these investors fled stocks and thus missed the subsequent market recovery. Investors with longer- term vision and steady risk tolerance maintained or

in some cases increased they exposure to volatile asset classes after or during the downturn. They more accurately reflected their true risk toler- ance. Of course, there were also some who held on only because of their reluctance to record losses. However, even these people enjoyed the benefits of holding on as the market rebounded. The point is that risk tolerance varies over time for many people.

Practical Comment Fluctuating Risk Tolerance

Chapter Ten Financial Investments 271

return. Why else would we expose ourselves to an above-average chance of loss? Generally, in finance, it is assumed that risk and return are proportionately related. It is a basic assumption of modern investment theory.3 For example, if we choose an invest- ment with a 20 percent higher risk, we should get a 20 percent higher return.4 Let’s look at the two factors, return and risk, separately.

Return Return is the total of income and the increase of monies invested over a period of time. We can establish the cumulative return using the following formula.

Holding period return 1HPR2 =

Sum of dividends or interest paid

+ Gain in principal invested

Original cost

We are often interested in calculating time-weighted returns. These returns affect how long we have owned a security and the timing of income payments during that period. The in- ternal rate of return (IRR) is often used to obtain this return, typically by providing a com- pound annual return.5 An example of holding period return (HPR) and IRR for a bond is provided in Example 10.1. The example details IRR for both a stock and a bond; the bond is expected to be held until it matures. In that case, the IRR is also known as the yield to maturity (YTM).

Example 10.1 Betsy bought a stock three years ago for $20 per share and placed it in a tax-sheltered pension plan. In years 1 to 3, she received cash dividends of $0.30, $0.60, and $1.00, respectively. She sold the stock for $28 per share the day she received the $1.00 dividend. She also purchased a bond in the pension plan for $960 on January 1. This bond would pay Betsy $50 of interest once a year until it was due to be redeemed at $1,000 after eight years. Calculate the actual HPR and IRR for her stock and the projected IRR/YTM for the bond.


Year 3: (28 + 1) = $29

General Calculator Approach Specific HP12C Specific TI BA II Plus

CF Clear the register f FIN 2nd CLR Work Enter initial cash outflow 20 CHS g CFo 20 +/− ENTER ↓ Enter cash inflow year 1 0.30 g CFj 0.30 ENTER ↓ ↓

Enter cash inflow year 2 0.60 g CFj 0.60 ENTER ↓ ↓

Enter cash inflow year 3 29 g CFj 29 ENTER ↓ ↓

Calculate the internal rate of return f IRR IRR CPT 14.6% 14.6%

3 Three prominent parts of this theory—modern portfolio theory, capital asset pricing model, and efficient market theory—are discussed in this chapter and in Web Appendix A: Modern Investment Theory. 4 After the risk-free rate, to be described, is considered. 5 We can calculate average annual returns when provided with annual or cumulative statistics. Average annual arithmetic mean returns are given as

Arithmetic mean returns = Sum of annual returns

Number of periods or

1 N

a N


rN and

Geometric mean returns = Number of Periods2Product of annual returns − 1 or N

Cq N


11 + rN2 − 1.

Calculator Solution

272 Part Three Portfolio Management

Risks Explanation

Market The risk of a decline in the overall stock or bond market Liquidity The risk of receiving a lower-than-market price on sale of a holding Economic The risk of unfavorable business conditions caused by weakness in the overall

economy Inflation The risk of an unexpected rise in prices that reduces purchasing power Political The risk of a change in government or governmental policy adversely affecting

operations Regulatory The risk of a shift in regulatory policy impacting activities Currency The extra risk in international activities arising from currency fluctuations Technological The risk of obsolescence of a product line or inputs in producing it Preference The risk of a shift in consumer taste Other industry The risks that affect companies in an industry other than the preceding ones Financial The extra risk that arises from borrowing money

TABLE 10.3 Fundamental Risks for Financial Assets


Year 8: (1,000 + 50) = $1,050

General Calculator Approach Specific HP12C Specific TI BA II Plus

CF Clear the register f FIN 2nd CLR Work Enter initial cash outflow 960 CHS g CF0 960 +/− ENTER ↓ Enter cash inflows years 1–7 50 g CFj 50 ENTER ↓

Enter number of years 7 g Nj 7 ENTER ↓

Enter cash inflow year 8 1,050 g CFj 1,050 ENTER ↓ ↓

Calculate the internal rate of return f IRR IRR CPT 5.6% 5.6%

The stock had a 14.6 percent annual return and the bond has a projected yield to maturity of 5.6 percent.

Risk Risk, as most people view it, is the chance of loss on an investment. There are many types of risk for financial assets (see Table 10.3). According to modern investment theory, the total risk of a security—one that includes all the fundamental risks shown in Table 10.2—can be represented by one measurement: its price action. The wider the fluctuations around its average price, the higher is the stock’s risk. The most common measurement of price fluctuation is the standard deviation.6

The idea of standard deviation and risk is shown in Figure 10.2. Notice that company A and company B both have the same return (they start and end at the same price), but company B has higher total risk because its price has fluctuated more widely. Essentially, standard devia- tion measures price volatility, and higher volatility is equated with increased investment risk. Because the standard deviation measures price change, it includes fluctuations that result in gains as well as those that result in losses. Therefore, this method contrasts with investors’ measurement of loss only. The semivariance, a less-used methodology, measures fluctuations resulting in losses.7

6 The standard deviation is the square root of the sum of the squared deviations around the average return. 7 Harry Markowitz, “Foundations of Portfolio Theory,” Journal of Finance 46, no. 2 (June 1991): 469–77. For an update on how Nobel Laureate Markowitz views his theory, see Sicco Brakema, “Don’t put all your eggs in one basket: An interview with Harry Markowitz,” September 11, 2013, thiscomplexworld. com/put-eggs-basket-interview-harry-markowitz/

Calculator Solution

Chapter Ten Financial Investments 273


We have discussed establishing goals and assessing risk tolerance and other factors. Before proceeding, we need to identify and review the investment alternatives that are appropriate for the asset allocation. We will review those most used by households—bonds, stocks, and mutual funds that are generally made up of bonds or stocks. In this way, you can be- come familiar with their investment characteristics such as their risk-return profiles and better understand how to employ them in the asset allocation process.

Bonds Bonds are contracts in which an investor lends money to a borrower. As compensation for receiving the money, the borrower agrees to pay interest, often twice a year and generally of a fixed amount. The borrower also agrees to repay a stated sum at the end of a fixed period. The date that the loan is to be repaid is called the maturity date.8

Bonds of high-quality companies are considered safer than most other types of invest- ments for the following reasons:

1. The annual income to be received is generally fixed in advance.

2. The contracted-for loan principal is likely to be repaid in full at the stated date.9 Even in the event of financial difficulties, the borrower will have to comply with the terms of the contract. Interest and principal must be repaid on time or the company will face bankruptcy. Should bankruptcy occur, bondholders have priority in receiving the proceeds from liquidation of business assets and are therefore repaid before stockholders receive any material proceeds.

Common Stocks Common stocks are very different from bonds. A common stockholder is an owner, not a creditor, of a company. She or he is entitled to participate in the current profits and anticipated future growth of the enterprise. Of course, if there are no profits, the investment can end up hav- ing no value. Clearly, stocks typically have higher risks than bonds. In sum, stocks present po- tentially higher returns than bonds, but the shareholder must be prepared to take a greater risk. Individual common stocks, also called equities, can be placed in various categories. Professional investors often concentrate on one or more of these equity categories.

FIGURE 10.2 Companies with Same Mean Returns but Different Risks

St oc

k Pr

ic e

Company A

Company B


8 Bond is the most popular term used for this type of investment, but a broader and perhaps more accu- rate term, fixed obligation, is sometimes employed. A fixed obligation is any investment whose terms, including the returns, are known at the beginning of the period or depend on clearly defined factors such as the inflation rate. Fixed obligations consist not only of bonds but also of other investments such as mortgages and bank certificates of deposits. Unless otherwise stated, we use the terms bonds and fixed obligations synonymously. Fixed obligations as they pertain to future household outflows described in Chapter 6, as opposed to future financial investment inflows as indicated here, have a different meaning 9 Unless repaid earlier, generally at the option of the corporation under terms stated in the contract.

274 Part Three Portfolio Management

Sometimes these professionals concentrate in this manner to ensure that they are never too far away from overall market performance or from the performance of the segment(s) of the stock market in which they operate. Some of the methods of categorizing stocks follow.

Relative Growth Rates Shares issued by companies that grow more rapidly in sales and earnings than the overall econ- omy and are less affected by cyclical business conditions are called growth stocks. Examples would be fast-growing technology leaders. Those that generally grow at average or below- average rates but are also less affected by business conditions are called defensive stocks. Companies in the consumer basics and utility sectors are examples of defensive companies. Firms whose growth rates are at or below those for the overall economy but whose operations are highly sensitive to aggregate business conditions issue shares called cyclical stocks.

Sector and Industry Sectors are the parts of the overall economy. The economic sectors that pertain to the stock market are sometimes divided into basic materials, capital goods, consumer cyclicals, consumer noncyclicals, energy, financial, health care, services, technology, transportation, and utilities. Each sector, in turn, is divided into a number of industries. For example, consumer cyclicals include, among others, autos, consumer appliances, and retail chains. Because sectors tend to share some similar characteristics, some active managers use these catego- ries and industries to decide which areas to over- or underemphasize.

Geographic Area Geographic area indicates which areas of the country or of the world we might concentrate in. For example, the northeast area of the United States is the most populated but slowest-grow- ing region. Some may be interested in investing in faster-growing sections of the United States or in parts of the world that present potentially more rapid growth rates than the United States.

Company Size Companies come in all sizes. As a generalization, larger companies are more secure often with entrenched positions in major markets. Smaller companies can be more flexible because they may have more entrepreneurial management. On the other hand, they also may have more risk if the outlook changes dramatically. Medium-size companies are a blend of the previous two.

Quality Quality in stocks is a measure of how confident we are that the anticipated prospects for a company are going to be fulfilled. Those companies of high quality are more likely to be large and have a strong position in their markets. Often they have good returns on investment and are less likely to have large noneconomic-related disappointments in earnings. Such companies are sometimes called blue chips and generally have risk that is below overall market averages. At the opposite end of the quality spectrum are companies whose operations are less predictable, their profitability more precarious with current or potential losses possible. Sometimes these companies have a large amount of debt in relation to the value of their equity. They can be highly risky and, if so, are called speculative investments.

Mutual Funds Mutual funds generally combine stock or bond assets10 for investors, who receive cen- tralized administration and investment management. In effect, people pay an investment company a yearly fee for handling their investment needs. Their investment is evidenced by shares of the mutual fund owned. Monies transferred to the investment company are

10 Other types of assets, such as asset-backed commercial paper held by money market funds, also are used.

Chapter Ten Financial Investments 275

pooled together with those of other shareholders for efficient management. This form of asset management has grown rapidly in recent decades, as shown in Table 10.4. The following are some selected mutual fund characteristics that have been separated into strengths and weaknesses.

Characteristics Explanation


Expertise Fund companies are typically run professionally, and the portfolio managers in charge of investment activities are generally qualified.

Low cost Mutual fund activities are provided at relatively low cost. Diversification Diversification generally into 50 or more stocks is possible with a modest sum of money. Low minimum investment The minimum investment to purchase many funds is as low as $500 to $1,000. Professional recordkeeping Records are kept by the fund management, who can provide information about performance

or for tax purposes. General information Published information (in print and online) and telephone assistance from the fund

management companies are generally available to help investors select mutual funds and monitor them. The information is either obtained by the individual or from a broker or financial planner.

Safety Mutual funds are supervised by the Securities and Exchange Commission and the fund’s board of directors. Actual assets often are not directly under the manager’s supervision but are placed with a third party with the manager making only buy and sell decisions.

Daily pricing This fund’s price and performance statistics are available daily in some publications, through Internet sites, or from the fund companies directly.

Reinvestment and payout Mutual funds can provide automatic reinvestment of their distributions and can accommodate the need for withdrawals of a stated amount per period.


Cost The overhead costs are higher than they would be if the investor were to manage the money him- or herself.

Performance The majority of mutual funds underperform their relevant markets. Tax Holders of mutual funds are subject to tax inefficiencies such as being taxed on realized capital

gains from individual stocks or bonds liquidated by the fund manager even though the fund itself hasn’t been sold by the investor.

Transparency Investors might not know exactly what’s in a mutual fund until it issues a quarterly report.

Industry Net Assets (billions of dollars)

Year Stock Funds Bond Funds Total11 Total Number of Funds

1970 45.1 2.5 47.6 361 1975 37.5 4.7 45.9 426 1980 44.4 14.0 134.8 564 1985 111.3 122.6 495.4 1,528 1990 239.5 291.4 1,065.2 3,079 1995 1,249.1 602.5 2,811.3 5,725 2000 3,934.5 824.0 6,964.6 8,155 2005 4,885.5 1,357.6 8,891.4 7,977 2010 5,596.6 2,591.0 11,833.0 7,554 2011 5,213.0 2,844.4 11,631.9 7,587 2012 5,938.8 3,390.7 13,052.2 7,588 2013 7,762.7 3,286.4 15,034.8 7,713 2014 8,314.3 3,460.9 15,852.3 7,923

TABLE 10.4 Total Industry Net Assets

Source: Investment Company Institute, https://www.ici.org/ pdf/2015_ factbook.pdf

11 Hybrid and money market funds are also included in total.

Mutual Fund Classification System Mutual funds cover virtually all types of stocks and bonds. With more than 7,500 in number, there are more mutual funds than stocks on the New York Stock Exchange.

276 Part Three Portfolio Management

Historically, funds were categorized by risk. Thus, general stock funds ranged from most conservative, income only, to aggressive growth. More recently, they have generally been listed by size and investment style.

Size Most mutual funds can be divided into small-company, medium-company, and large-company categories. The basis for this separation is the stock market’s valuation of the companies in which the mutual fund invests. Smaller capitalization companies provide higher potential returns because they may have the potential for faster growth and have more managerial flexibility than large firms. However, “small-caps” also have higher risk because they may not be as diversified as larger companies. Larger capitalization companies have more consistency of performance and lower company fundamental and stock market risk.12 Medium capitalization companies provide a blend of the other two categories.

Investment Style The many styles of active investment are commonly separated into three categories: growth, value, and blend (or core).

• Growth. A growth style of investing involves selecting companies that are expected to have rapid growth in revenues and earnings per share. These companies are more likely to be favorably thought of by investors and have higher-than-average valuations such as high price/earnings multiples.

• Value. An investor employing a value style places more emphasis on price in making pur- chase decisions. The manager looks for companies that are out of favor or otherwise mis- priced in relation to their outlook for earnings growth. The valuations of such ratios as their market price in relation to their earnings (price/earnings ratio) or market price in relation to their asset value as recorded on their books are likely to be below average. Their universe of stocks is broader, often with more emphasis on companies whose earnings growth or re- turn on investment is temporarily or permanently below that for the average stock.

• Blend. The blend category is essentially all else. It may include a fund run by a man- ager who moves from value to growth style or buys a mix of the two. A blend fund also may practice a style of investing that cannot be defined in value or growth terms as, for example, a fund with a manager who largely uses technical analysis.

Example 10.2 Helen had a choice of three styles of larger company mutual funds for her pension. The first, a growth style, picked the fastest-growing companies in industries with favorable outlooks such as those in the technology sector. The second, a value style, selected individual companies that had some blemishes in outlook but were soundly positioned and financed and were cheaply priced. The third, a blend style, was a mixture of the other two styles. She decided to select the value style fund, which suited her belief in making purchases for her household that were “bargains” and therefore represented value investments.

A sample grid employing these principles for stocks is shown in Figure 10.3.

12 Of course, many believers in risk-return theory and efficient markets regard the two as synonymous.

FIGURE 10.3 Morningstar Investment Style Box

Source: Morningstar, Inc.

Morningstar Style Box™

Large M

id Sm


Value Blend Growth ---------Style--------


Chapter Ten Financial Investments 277

Exchange Traded Funds Exchange traded funds (ETFs) are in many ways like mutual funds. They differ from mutual funds in that a majority of ETFs are managed passively to track a specific market index. ETFs pool together investors’ monies for joint management. Their popularity has grown rapidly in recent years. Like passively managed mutual funds, ETFs typically have a lower cost structure. In comparison with mutual funds, ETFs can possess certain modest tax benefits. Because ETFs track market indexes, they offer investors a chance to match returns from the overall and individual segments of the stock and bond markets, com- modities markets, currencies, and so on; some ETFs have innovative methods for con- structing indexes via mathematical means. Unlike mutual funds, which can be purchased only once a day at the market value of their individual assets, ETFs are traded like stocks throughout the day, generally but not always at a price close to the market value of their individual holdings. For purposes of this chapter we treat ETFs as being very similar to mutual funds.


Individual preferences create issues and choices in the way investments are managed. Two of them—active versus passive investing and use of individual securities versus mutual funds—are discussed next.

Active versus Passive Approach Risk-return and efficient market theory say that attempting to outperform the market will not be fruitful. People who manage to do so are just lucky, not skilled. This thinking leads to a passive approach to investing. With it, no attempt is made to receive higher- than- market returns. The theory’s proponents believe that efforts can better be used to diversify in order to reduce risk and keep costs low. Passive investors tend to purchase index mutual funds or ETFs of all types. An index fund attempts to duplicate market performance and

Too much is made of the differences between mutual funds and ETFs. In fact, in one segment of the market—the individual investor—ETFs have to some extent taken on a modern, behavioral, better performing image. For that and other reasons, ETFs have proliferated rapidly. These funds have distinct advantages for portfolio managers who can trade into or out of segments of the stock, bond, commod- ity, and currency markets all during the day. Some ETFs offer choices for sectors and styles that aren’t available through mutual funds. On the other hand, the costs of ETFs are generally not lower than the costs for indexed mutual funds. In fact, the costs of ETFs with proprietary approaches can be materially higher than those of indexed mutual funds even

though most of the former don’t have portfolio managers or research departments. For individual investors, many of whom tend to want to sell when markets are shocked by unexpected negative news, the intraday trading of ETFs at that time can result in a sales price significantly below that of the then-market value of the ETF’s holdings, clearly a distinct negative. Those who are considering ETFs should assess their strengths and weaknesses versus mutual funds and individual stocks and bonds in a logical way. On balance, ETFs, although a legitimate investment alternative, may offer no significant performance advantage over mutual funds for the unsophisticated investor.

Professional Advice ETFs

278 Part Three Portfolio Management

keeps costs low by using computerized programs to purchase holdings and not employing high-priced investment managers and analysts.13

With the alternative, the active approach to investing, changes are made in holdings over time to take advantage of new opportunities. There are many different ways of per- forming active investing. However, they all have as their basis the belief that it is possible to outperform the market. Otherwise, it would be silly to make the effort. One prominent active approach is fundamental investing, which analyzes overall market, industry, and company data to identify opportunities. Often the basis of this approach is the belief in mean reversion. Mean reversion is the belief that security prices return to their true value over time from temporary overvaluation or undervaluation. For example according to mean rever- sion, investors who purchased shares in 2008 when they were undervalued and had declined more than 50% from the peak, were able to earn above average returns when stocks rebounded to more normal levels in subsequent years.

Individual Securities versus Mutual Funds Establishing an investment portfolio should involve making a decision about whether to use individual securities or mutual funds.14 Individual securities purchased by the household in- volve no fund-overhead expenses and offer more ability to buy and sell for tax planning pur- poses instead of dealing with annual taxable capital gains from mutual funds. With individual securities, there also can be the emotional “high” of watching a stock in the portfolio do well. Mutual funds offer professional advice at reasonable cost, the ability to delegate the investment management and recordkeeping function, and simple diversification with low investment minimums by specialists in a wide variety of types of securities, geographic areas, and styles of investing. Although there are notable exceptions, the majority of mutual funds underperform the market. Given the lack of expertise in many households, the lack of desire to monitor their investments, a sometimes emotional response to buy and sell decisions, and a desire for lower volatility, the majority of financial planners recommend implementing investment strategies through mutual funds.

13 It is generally included under the blend style of investing. Nonbelievers might say people at the time couldn’t be sure a major depression wouldn’t break out with even lower stock prices an outcome. 14 Actually, mutual funds represent just one of a number of investment alternatives including the use of separate accounts and the direct selection of investment managers, tax-deferred annuities, hedge funds, exchange-traded funds, unit investment trusts, and so on. However, in this introductory text, we have largely limited ourselves to this most popular alternative.

The reason for mean reversion over an extended time period may be human weaknesses such as overem- phasis on near-term developments and lack of vision of longer-term events, or insufficient weighting given the random nature of unexpected occurrences. Unexpected occurrences, both good and bad, can affect highly and poorly regarded companies equally. Mean reversion can be viewed as a modified form of efficient markets. It can be interpreted as indicating

that markets and individual securities may not be fairly priced over shorter periods but move toward efficiency over the longer term. That is, they reflect appropriate returns after adjustment for risk over extended periods. In shorter time frames, securities may be over- or underpriced, which presents potential opportunities for abnormal returns through funda- mental analysis.

Practical Comment Why Mean Reversion May Work

Chapter Ten Financial Investments 279


Portfolio management is the overall supervision of our investments program. It guides the decisions on asset allocation and individual investments. Each household does or should en- gage in portfolio management, which helps answer such questions as “Are my investments too concentrated in one area?” and “What returns am I likely to receive longer term.” In this section, we discuss the principles that help establish portfolio management policies. We have already described the characteristics of individual stocks and bonds and how both risk and household needs enter into decision making. Our approach was to look at each asset separately and decide whether it was attractive enough to purchase. There is a major weakness in using this approach.15 It assumes that a portfolio is just the sum of all its individual securities. Adding up all individual securities is roughly equivalent to saying that a house is only the sum of all the bricks and other materials that went into building it16 with no weight given to the safety and attractiveness of the building taken as a whole. Similarly, a portfo- lio is more than the sum of its parts because the individual assets are often related to each other. The interrelationships among the securities can create an attractive or unattractive portfolio just as the way the bricks are put together can create a beautiful or ugly house. A portfolio can be defined as a grouping of assets held by an individual or a business. A portfolio that holds a diversified grouping of assets can be said to be at- tractively balanced and not easily influenced by events other than those that affect overall markets. We also learned that individual securities are valued not only by the returns they offer but also by the risk they present in receiving their return. The two-parameter risk-return approach, here termed the mean-variance model,17 serves as the basis for portfolio theory and its approach to constructing a portfolio.18 Under portfolio theory, we strive to achieve the highest return we can given the risk we are willing to undertake. Let’s look at portfolio risk and return separately. Portfolio return is fairly simple. It is just the sum of the returns for each security multi- plied by the weighting it has in the portfolio. You might think, then, that portfolio risk is the weighted average sum of the risk for the individual securities. That isn’t the case. The reason has to do with the correlation coefficient. The correlation coefficient measures the degree to which an investment in a portfolio is related to other investments in that portfolio. As a practical matter, for financial invest- ments, it generally ranges from 0 to +1.19 Often in portfolio management, we measure

15 Of course, as we see later in this chapter, there is a second possible weakness. For people who believe in efficient markets, the effort to find attractive stocks will be fruitless. 16 Just as we look at a house overall and decide whether it is attractive or unattractive, we can look at a portfolio overall and decide whether by placing the right investments in the right proportion we have a grouping of assets that appropriately answers our risk-return needs. Just as one building material may look attractive by itself but not fit the overall house effect, individual securities relate to one another, and one that is attractive may not fit in with an individual’s point of view. 17 The variance measure of risk is just the standard deviation squared. 18 Harry Markowitz, “Portfolio Selection,” Journal of Finance 7, no. 1 (March 1952): 77–91; “The Early History of Portfolio Theory: 1600–1960,” Financial Analysts Journal 55 (1999): 5. See also Bruce I. Jacobs and Kenneth N. Levy, “A Comparison of the Mean–Variance-Leverage Optimization Model and the Markowitz General Mean–Variance Portfolio Selection Model,” Journal of Portfolio Management (Fall 2013), iijournals.com/doi/full/10.3905/jpm.2013.40.1.001#sthash.Sn7Llo0F.BSTimMBg.dpbs 19 In theory, its range is wider, from +1 to –1. Investments can be negatively correlated, which means that when one rises, the other goes down. As a practical matter, negatively correlated investments are difficult to find.

280 Part Three Portfolio Management

correlation through movements in prices. That is so because price changes often largely determine performance, the reason for investing. Think of correlations as showing rela- tionships. We aren’t going to get much portfolio diversification benefit from investing in Coca-Cola, PepsiCo, and Dr Pepper Snapple Group. The movements of these stocks tend to be very similar and therefore have high correlations. Combining a beverage company with a smaller technology company and a low-valuation automobile company would reduce the correlations. By reducing correlations, we lessen price fluctuations and overall risk in the portfolio. Noncorrelation between asset classes also can reduce portfolio risk. In this century, for instance, long-term Treasury bonds have been negatively correlated with the broad stock market as represented by the Standard & Poor’s 500 Index. In 2008, large-cap domestic stock funds lost 38 percent on average whereas long-term government bond funds gained 28 percent. Thus, a portfolio split evenly between those two asset classes would have lost 5 percent for the year whereas portfolios tilted toward stocks lost 20 percent, 30 percent, or more. According to Markowitz, forecasts of return, risk, and correlation20 are combined to form what is called the mean-variance model. Its principles are key inputs into what is termed modern portfolio theory (MPT). The model computes the mix of portfolio assets that best meets the household’s return-risk profile. The Markowitz model and its simpli- fied off-shoot, the capital asset pricing model (CAPM), are provided in Web Appendix A, Modern Investment Theory. We can conclude by saying that the most important concern to the investor is the risk of the overall portfolio, not the risk of individual securities. The portfolio risk reflects the separate risks of each of its holdings and the degree to which the securities are correlated.

Total Portfolio Management (TPM) The Markowitz portfolio approach is, at heart, a theory of how overall capital markets work using individual securities. The CAPM has similar intentions. In contrast, total port- folio management (TPM), presented by the author of this book, is a more inclusive model of the individual household. It proposes that a household makes investment decisions based not only on marketable financial securities but also on all assets that it possesses. Although we have referred to portfolio analysis as employing securities, its approach can embrace all assets. In fact, Markowitz has made reference to doing so.21 The concepts we have explained thus far in the chapter apply to TPM as well. Under TPM, all household assets interact and their correlations are considered. Investment decisions that are made incorporate individual asset returns, risks, and the degree to which they are correlated. The traditional view is to treat financial assets such as stocks and bonds separately from other household assets. Although this solely finan- cial asset approach can be considered too narrowly focused, it is established thinking, and we have followed it in this chapter. The other components of TPM—real assets, hu- man and human-related assets, and liabilities—have been or will be discussed in other chapters. We deal with total portfolio management with its full integration of all assets in Chapter 17.

20 Actually, correlation is part of portfolio risk, and risk in this sentence refers to individual asset risk. It is segregated in this manner to differentiate it from the CAPM, which simplifies correlation to individ- ual assets relative to the overall market, thereby bypassing individual asset correlations with other port- folio assets. 21 Markowitz called them exogenous assets. For further details, see Harry Markowitz and Peter Todd, Mean-Variance Analysis in Portfolio Choice and Capital Markets (New Hope, PA: Frank J. Fabozzi, 2000).

Chapter Ten Financial Investments 281


We have now examined all the major factors that enter into the asset allocation process. The next part of the operation, taking portfolio management actions, can be viewed as the decision-making implementation arm of the asset allocation process. We assume that goals and evaluation of personal characteristics, including such factors as time horizon and risk tolerance, have been established. The remaining steps are listed next and then described separately.

1. Establish an active or passive management style.

2. Construct a strategic asset allocation.

3. Develop a tactical asset allocation.

Establish an Active or Passive Management Style At this point in the process because passive management may provide fewer investment choices and a simpler process, it is important to decide whether the portfolio is to be actively or passively managed. Underlying the active approach is the belief that changes can add to portfolio performance. With passive management, no attempt is made to antici- pate future events. Changes under passive management are made to maintain a constant asset allocation and risk profile, not to improve returns, and costs are kept very low. As mentioned, index-type assets such as index funds are often used in implementing a passive management approach.

Construct a Strategic Asset Allocation Asset allocation is the percentage makeup of the portfolio by asset type. Strategic asset allocation is the normal portfolio makeup over the longer term. The strategic allocation process begins by establishing allowable asset categories. This might include small, mid, and large cap stocks; international equities; and bonds or their mutual fund counterparts. Other categories may be eliminated, such as tax-free municipal bonds if the household’s marginal tax bracket is modest or private partnerships if the amount of assets or tolerance for risk is low. The strategic asset allocation stresses diversification.

Risk-return analysis, MPT, CAPM, and the efficient market hypothesis are very controversial among aca- demics and practitioners alike. Many claim that the theories don’t work in day-to-day analysis and cite academic tests that bear this out.22 On the other hand, some advisors employ MPT and CAPM proce- dures, more often as an input to decision making than as the sole decision tool. Even if MPT – CAPM don’t fully work,23 it’s hard to disagree with the thought that risk and return are related. The majority of financial planners and other invest- ment advisors engage in portfolio management and attempt to diversify portfolios. Few use Markowitz portfolio theory techniques that imply that planners and managers can find the single best portfolio for a

household. Instead, planners often separate clients according to risk tolerance—for example, into con- servative, moderate, and aggressive categories—and often make even more distinctions. Typically, they then provide mixes of stocks and bonds to imple- ment portfolios. As we discuss in the next section, specific asset allocations are usually based on that stock-bond mix. 22 See Eugene Fama and Kenneth French, “The CAPM Is Wanted, Dead or Alive,” Journal of Finance 51, no. 5 (December 1996): 1947–1958. See also Nicholas Barberis, Lawrence Jin, and Andrei Shleifer, “X-CAPM: An Extrapolative Capital Asset Pricing Model,” Harvard Business School (2013), people.hbs.edu/rgreenwood/bgjs9.pdf 23 One reason could be the lack of inclusion of all household asset categories within TPM.

Practical Comment Use of Modern Investment Approach

282 Part Three Portfolio Management

The strategic allocation should be strongly influenced by the household goals and risk profile. For example, if the goals can easily be achieved, a conservative asset allocation may be used even though the household can tolerate a more aggressive one. A shorter-term goal also will dictate a more conservative allocation. Financial advisors generally suggest that a strategic asset allocation be rebalanced periodically. Suppose that Arlene began 2008 with a simple asset allocation of 50 percent in a long-term government bond fund and 50 percent in a large cap domestic stock fund. At year-end 2008, strong performance by government bonds and weak performance by domestic stocks tilted her allocation to 65 percent in bonds and 35 percent in stocks, a much more conservative position than Arlene desired. To regain her target allocation, she sold an amount of her bond fund shares equal to 15 percent of her portfolio value and rein- vested the sales proceeds in stock fund shares. This brought Arlene back to her strategic 50–50 allocation. In reality, such rebalancing usually involves multiple asset classes rather than only two. Overall risk tolerance, as discussed, can incorporate many factors. As a rule, the younger we are, the more aggressive is the allocation. An example of strategic allocations by age and presumed tolerance for risk is given in Table 10.5.

TABLE 10.5 Strategic Asset Allocation

Asset Category Middle Aged/ Moderate Risk

Retired/ Lower Risk


Small cap 15% 10% 5% Mid cap 10% 5% 2% Large cap 25% 30% 20% International 20% 15% 5% REIT 5% 5% 3% Total Stock 75% 65% 35%


Short term 5% 5% 10% Intermediate 5% 10% 25% Long term 0% 5% 10% High yield 10% 5% 5% Total Bond 20% 25% 50%

Money market 5% 10% 15% Total 100% 100% 100%

Young/ Fairly Aggressive

The relative performance of active and passive man- agement can vary over an investment cycle. Therefore, the popularity of one over the other can change at any point in time. However, as mentioned, the disagreement concerning approach is unlikely to end soon. The proponents of an active approach point to past opportunities and investment managers who they believe have systematically

outperformed the overall market. They say that passive management results in mediocre and even below-average performance after the deduction of expenses. The passive managers either think it is not possible to outperform after deductions of expenses or don’t believe they can or want to expend the time to do so and don’t want to delegate the job to active managers.

Practical Comment Active versus Passive Investing

Chapter Ten Financial Investments 283

Develop a Tactical Asset Allocation A tactical asset allocation modifies the breakdown of a portfolio to attempt to profit from current circumstances. When constructing a tactical asset allocation for the current eco- nomic environment, the outlook for asset categories and prevailing asset valuations are included. Often, maximum allowable deviations of the tactical asset allocation from the strategic one will be set. The illustration involving Arlene showed that she had a 50–50 strategic allocation be- tween long-term government bonds and large cap U.S. stocks. She also has a tactical incli- nation that varies from time to time, depending on the outlook for interest rates, economic growth, and other factors. However, her investment policy puts a band of 5  percentage points, in either direction, on her ability to move for tactical reasons. Thus, Arlene can make a tactical allocation of up to 55 percent from 50 percent for either stocks or bonds. If she believes that the current outlook favors stocks over bonds, Arlene can sell enough bond fund shares and reinvest in stock fund shares to move her allocation to 55–45, stocks to bonds. Alternatively, she might put new money into stocks so that the 55–45 allocation results. As conditions change, allocations are altered. When a passive approach is taken, a tacti- cal asset allocation is not performed. Some people and advisors skip the tactical asset allocation as well, preferring a fixed strategic allocation at all times.


Once the strategic and tactical asset allocations have been established, individual assets24 are selected for each category. Clearly, the goal is to select the assets that provide the high- est returns for the overall risk taken.

Individual Fund Analysis Asset allocation typically involves placing monies in a wide variety of areas. For the majority of individuals and financial planners, mutual funds are the appropriate and most

The book has advocated a theory of including all assets and liabilities in making household decisions. The portrayal of Social Security and corporate and union pensions as human-related assets is consistent with this approach. Their streams of retirement income provided are most similar to the income pro- vided by bonds. Moreover, both Social Security and corporate and union pensions have a government- backed guarantee of payout. They should be added to the bond allocation in making decisions on invest- ment mix. To understand, think of two families, identical in every respect including age, total

financial assets, Social Security payments, risk toler- ance based on personality, and cost of living except for one fact: one family will receive a corporate pen- sion of $50,000 per year and the other will not. The couple expecting a pension is in a safer position and therefore should consider a higher allocation to risk- ier assets such as stocks and a lower allocation to bonds. Said differently, one couple already has a higher allocation to a bondlike substitute, that cor- porate pension, which generally isn’t considered by most advisors.

Professional Advice Pensions and Assets Allocation Strategy

24 As one entity, a mutual fund is also considered an individual asset.

284 Part Three Portfolio Management

popular form of managed account. Here we focus on how to select an individual mutual fund. This approach can be useful for other asset types as well. Individual fund ideas can come from media recommendations, advisors, friends, or our own examination of a mutual fund database. With passive management, the prime screen may be the availability of a diversified mixture of funds benchmarked25 to the categories stated in the asset allocation. The final choice for passive management might include exchange-traded funds as well as traditional mutual funds, selected on the basis of their correlation with the benchmark, with those having the lowest expense ratios and the high- est returns preferred. Active fund selection is more involved. With the exception of step 1, the information for which can be accessed independently such as receiving it from the management com- pany, broadly speaking the factors listed in the steps given below or similar steps can be found in a good statistical source such as Morningstar. Morningstar has excellent subscrip- tion services and offers free online access to selected information on virtually all mutual funds. You can see how to use the selected information at no charge by examining the Morningstar page provided in Figure 10.4. Note that beginning with step 2 each of the steps listed are keyed to the relevant information given in the Morningstar page. For example, step 2 calls for indentifying the fund’s size and style. Both are shown as step 2 on the Morningstar page. The steps listed below are enough to make informed decisions. Appendix III provides selected additional factors that are helpful. On the other hand, a simpler approach is given in the Professional Advice section following.

1. Try to obtain relevant descriptive information on the fund. Information written by the press, the management company, and industry sources can help.

2. Identify the fund size and style. The size of the companies it has in its portfolio and the style of investing are the appropriate beginning point for analysis.

3. Compare fund returns. Comparison should be with other funds with the same size and style. In theory, all markets move together. In reality, this isn’t always true. For example, large cap growth funds were up an average of 15.7 percent a year for the five-year period ending August 31, 2015 whereas small cap value was up 13.4  percent a year for the same period, a significant difference. Comparing apples with apples— for example, small cap growth with small cap growth indexes—will provide the most insight.

4. Look at the fund’s risk. Know the risk that being taken relative to the category and to the overall market. The beta coefficients and the standard deviations can provide the informa- tion. A beta coefficient of 1 indicates average risk relative to the index it is compared to. A beta above 1 indicates above-average risk; below 1, below-average risk. The higher the standard deviation, the higher is the risk of the security. The S&P 500 for the three-year period ending August 31, 2015, had a standard deviation of approximately 9.6  percent. Thus, a fund with a standard deviation higher than 9.6 percent has been more volatile than the broad market. The higher the fund’s Sharpe ratio, the better is its performance. Interpreting the alpha coefficient is even easier. A positive alpha coefficient indicates above-average risk adjusted performance; the higher the figure, the higher is the amount by which it exceeded the yearly market performance. Similarly, a negative alpha indicates negative risk adjusted performance. Obtain Sharpe ratios and alpha coefficients relative to

25 Benchmarked means taking an overall index that is closest in characteristics to the individual portfolio that has been established. Then overall performance can be compared with that benchmark. For example if we had a portfolio of larger companies, we could see how well we had done by comparing it with the S&P 500 as an index of the 500 largest companies in the United States.

Chapter Ten Financial Investments 285

other funds like it.26, 27 Unfortunately the risk measure given by Morningstar is only their assessment of risk of the individual fund relative to the category.

5. Look at consistency of performance. Performance should be measured over a minimum of three years and preferably five years or more. Fund performance that ranks in the top quartile for four out of five years may be preferable in anticipating future returns to an alternative that has higher cumulative returns but received all cumulative outperformance in only one out of five years. The Morningstar chart allows only cumulative ranking over 1, 3, 5, and 10 years and consistency must be imperfectly deduced from these statistics.

6. Look at the tenure of the current portfolio manager. With some exceptions, portfolio managers are the individuals most responsible for fund records. Once they leave, the records may be meaningless when attempting to forecast future performance.

7. Observe the fund’s size. Many equity portfolio managers admit that it is easier to man- age $50 million than $500 million, $500 million than $5 billion, and so on. Bond fund managers in broad-based high-quality funds may not have that difficulty.

8. Incorporate the fund’s expense ratio. For all share classes28 the average expense ratio for domestic stocks is 1.21 percent of net assets per year29 and for bonds is 0.86 percent.30 For no-load, no 12b-1 fee share classes the fund average expense ratio for domestic stocks is 0.90 percent and for bonds is 0.57 percent. Deviations well above or below that level can have an impact, particularly for bond funds. According to Morningstar, portfolio transaction fees, or brokerage costs, as well as initial or deferred sales charges aren’t included in the expense ratio. 31, 32

The factors listed in the steps given above can all be found in a good statistical source such as Morningstar. You can see how to do so by examining the Morningstar page

26 See Appendix III this chapter for additional measures for fund analysis. 27 See Appendix II this chapter for further information on these measures and Part III of Web Appendix A for additional elaboration on risk measures. 28 All share class funds include B and C fund shares which have higher operating expenses to compensate the broker selling the fund. 29 Domestic large, mid, and small cap stock funds, for both all funds and just no-load funds calculated from Morningstar data. 30 Domestic long-term, intermediate-term, and short-term bond funds excluding municipal bonds, for both all funds and just no-load funds calculated from Morningstar data. 31 Those stock and bond funds in the same categories identified by Morningstar as being no-load tend to have lower expense ratios than those for funds that impose loads, the industry term for sales charges. 32 Expense ratios include management fees, 12b-1 fees for marketing and administration, operating costs, and all other asset-based costs incurred by a fund.

The previous analysis provided a roadmap for selecting individual funds. An abridged version would have you select funds with a favorable record of long-term growth as reflected by the funds’ 3-, 5-, and 10-year records. Relative to their benchmark per- formance, they should have a strongly positive alpha, the measure of risk-adjusted return, and should show consistency in performance as indicated by generally being in the upper half and sometimes upper quar- tile of performance. Performance comparisons

should be made with other funds or versus index tracking firms with the same size and style, not with the overall stock market. Make sure the manager who recorded the excellent performance is still at the helm. Finally, don’t pick the fund with the best record in the category—the chances are it has so much money under management and so much com- petition from other managers who will mimic its moves, that the once-top performing fund will be diluted into mediocrity.

Professional Advice Short Form Selection Process

286 Part Three Portfolio Management

FIGURE 10.4 Steps in Active Fund Selection

Source: Morningstar© Mutual Funds™, downloaded from http://quotes.morningstar.com/ in August 2015.

7 82



1 5



Chapter Ten Financial Investments 287

FIGURE 10.4 (concluded)

provided in Figure 10.4, which is keyed to the step numbers above. For example, for step 3 Oakmark Select, a large blend fund, is compared with the S&P 500 Index, demonstrating the amount by which the fund generally outperformed this index. Finally, a significant number of financial planners use modern investment theory risk–return concepts such as overall portfolio analysis and examination of beta, alpha, standard deviation, and correlations. Although some planners use a passive approach including index funds, the majority use these figures to support rather than provide automatic approval for an investment in the decision-making process. In other words, modern investment theory statistics are one ingredient to help an advisor make a judgment as to when to make changes in a portfolio.


At this point, the entire portfolio is checked overall. The following questions may be asked: Is the portfolio consistent with the overall tolerance for risk? Can risk be reduced with little sacrifice in return? Simply put, am I properly diversified and will my portfolio produce attractive returns? Further changes may be made to accomplish these objectives. When finished, the portfolio is implemented. An example of the diversification process by financial asset category is given below.

Example 10.3 Steve, who is 45, has set up his own strategic asset allocation based on his tolerance for risk. Because of current circumstances, Steve decides to vary his approach slightly and adopt a tacti- cal asset allocation instead. He believes that inflation will be higher than what investors expect and observes that small cap funds have valuations well below their historical level relative to mid and large company stocks. He further believes that large cap stock valuations are high relative to historical levels. Steve does

288 Part Three Portfolio Management

Asset Category Strategic Asset

Allocation Tactical Asset

Allocation Explanation


Small cap 10% 20% Attractive relative valuation Mid cap 5% 5% Large cap 20% 10% Unattractive relative valuation International 15% 15% REIT 5% 5% Total Stock 55% 55%


Short-term 5% 10% Not as affected by higher inflation Intermediate 15% 5% Higher-than-expected inflation is

anticipated to result in weak performance

Long-term 5% 0% Same as intermediate, only even weaker results

Inflation-indexed 0% 10% Benefits from higher inflation High-yield 10% 5% Can be negatively affected by higher

interest rates Total Bond 35% 30%

Money market 10% 15% Will easily reflect expected increases in current interest rates

Total 100% 100%

not think bond-fund managers can predict interest rates but believes they can take advantage of relative valuations among sectors of the bond market. He has two short-term bond funds he is looking at: one has had the highest absolute return, the other the highest risk-adjusted return. He also has two small cap stock funds that are almost identical in most respects. An exception is that one has a correlation with the S&P 500 of .90 and the other a .30 correlation. Steve’s strategic and tactical asset allocations are shown below along with an explanation of the difference.

A variety of theories and academic studies show that the reactions of investors to new circumstances are less than optimal. Among other things, investors can be overconfident,33 overreact to new information,34

be too short term in their thinking,35 and follow what others are doing.36 Such responses can result in underperformance. They argue in favor of maintain- ing investment positions and using mutual funds for people prone to this type of behavior. We will dis- cuss behavioral financial planning in Chapter 18.

33 Brad M. Barber and Terrance Odean, “Trading Is Hazardous to Your Health: The Common Stock Investment Performance of Individual Investors,” Journal of Finance 55, no. 2 (April 2000): 773–806; and James Scott, Mark Stumpp, and Peter Xu, “Behavioral Bias, Valuation, and Active Management,” Financial Analyst Journal 55, no. 4 (July–August 1999): 49–57.

34 Kent Daniel, David Hirshleifer, and Avanidhar Subrahmanyam, “Investor Psychology and Security Market Under- and Overreactions,” Journal of Finance 53, no. 6 (December 1998): 1839–85; and Werner F. M. De Bondt and Richard H. Thaler, “Further Evidence on Investor Overreaction and Stock Market Seasonality,” Journal of Finance 42, no. 3 (July 1987): 557–81. 35 Brad M. Barber, Graduate School of Management, University of California; Yi-Tsung Lee, National Chengchi University; Yu-Jane Liu, Guanghua School, Peking University, and National Chengchi University; and Terrance Odean, Haas School of Business, University of California, “Just How Much Do Individual Investors Lose by Trading?”, Review of Financial Studies, 2009, faculty.haas.berkeley.edu/odean/Papers%20 current%20versions/JustHowMuchDoIndividualInvestors Lose_RFS_2009.pdf 36 Meir Statman, “Investor Sentiment, Stock Characteristics, and Returns,” Journal Of Portfolio Management, Spring 2011, scu.edu/business/finance/research/upload/Sentiment- charateristics-returns-JPM.pdf

Practical Comment Behavioral Principles

Chapter Ten Financial Investments 289

People often have difficulty fully understanding the overall portfolio concept.37 They can appreciate the idea of diversifying to reduce risk. However, the idea of correlations affecting portfolio risk and purchase decisions that are significantly influenced by the goal of achieving lower correlations among holdings can be hard to convey. People often think one asset at a time. They ask, “Why shouldn’t I select the best-performing assets I can?” They will point to an individual security that lags behind other portfolio holding performances in a strong economic and stock market environment

and say, “Shouldn’t I get rid of that dog?” The answer may be no because that asset will reduce overall port- folio fluctuations and could outperform in other eco- nomic and stock market environments. It can help to introduce the idea of portfolio blending. Performance is expressed not in return alone but in risk–return terms. An investment is pur- chased not because of its appeal by itself but due to its effect on overall portfolio performance. A num- ber of examples in daily life, while not exactly paral- lel, help explain this point.

Practical Comment Understanding the Portfolio Concept

Type Explanation

Basketball A team with four high-scoring, high-ego players may benefit from adding a player who cannot shoot a ball himself but knows how to pass well and can keep the others happy and productive.

Dressing style Individual items of clothing may be attractive in themselves, but care must be taken that they don’t clash when putting together a daily “dressing portfolio”—for example, wearing a plaid shirt, tie, and jacket all at one time.

Salad Vinegar might be an unpleasant taste by itself but can produce a pleasing taste in a salad of fresh vegetables.

The financial point of placing less-correlated assets into a portfolio to reduce portfolio risk, even

when understood by clients, is often forgotten and therefore should be revisited frequently.

37 The work by Friend and Blume shows that individuals who are not well diversified would support this contention. See Marshall E. Blume and Irwin Friend,

“The Asset Structure of Individual Portfolios and Some Implications for Utility Functions,” Journal of Finance 30, no. 2 (May 1975), pp. 585–603.

Even though it had a lower absolute return, Steve selected the short-term bond fund with the highest risk-adjusted performance knowing that there typically is no “free lunch” for returns as far as investment performance is concerned. He also selected the small cap fund with the lower correlation coefficient, which he figured would reduce his portfolio risk while adding to the asset category he preferred.


As time moves on, the economic outlook and relative valuations change, as do household circumstances. Both passive and active investors must take into account current actual allocations relative to strategic ones and consider making changes. Active investors may want to purchase newly attractive securities and sell old ones that no longer fit perfor- mance requirements. A performance evaluation reviews past results. It should be done for an existing portfo- lio with the goal of answering the following questions: “How did I do?” “What were the reasons for the under- or overperformance?” “What can I do to improve future perfor- mance?” The evaluation also should be done when examining a potential future holding as,

290 Part Three Portfolio Management

College Age • Know the basics of stocks and bonds.

• Invest in at least one stock that others would say is respectable.

• Develop an understanding of business and the economy.

• Consider speculating by putting a small portion of your savings in one common stock flyer: Heck, with your empty pockets and student debt, how much can you lose?

Twenties • Unless you are saving for the down payment on a house, place the majority of your savings in tax-advantaged retirement accounts.

• Become knowledgeable about the broad categories of stocks and bonds.

• Utilize mutual funds and ETFs unless you’re willing to follow individual investments on an ongoing basis.

• Emphasize stock mutual funds for growth; make missteps and your future income will bail you out.

Thirties • Begin to loosely develop a portfolio of assets.

• Maintain a majority in stocks through mutual funds or ETFs.

• Place moderately more emphasis on bonds as a diversification tool.

• Pay more attention to risk–return principles; your family will be grateful.

Forties • Take on a structured portfolio of assets.

• Maintain a majority in stocks through mutual funds or ETFs.

• If previously small, place moderately more emphasis on bonds as a diversification tool.

• Pay more attention to risk–return principles.

Fifties • Review performance relative to appropriate benchmarks.

• Recognize portfolio manager styles of investing and diversify them, perhaps with a value tilt.

• Keep on an even keel to maintain constant asset allocation. • Reduce your asset turnover; you’re older and wiser now and have more patience.

Sixties • Unless it really disturbs you, resist the temptation to become more conservative prema- turely; you may have more than a quarter century to go.

Seventies and Beyond • You can, if you wish, gradually reduce your allocation to equities.

Life Cycle Planning Financial Investments

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Chapter Ten Financial Investments 291

for example, a mutual fund. The questions to be answered in both cases are somewhat similar: “How did the investment do?” “What were the reasons for the under- or overper- formance?” “What does it suggest for future performance?” “How does or will that fund and its performance fit into my portfolio?”

Back to Dan and Laura FINANCIAL INVESTMENTS Dan and Laura came prepared for our discussion on financial investments. They had thought about the investments they were attracted to and mentioned to me that they be- lieved that smaller companies were to their liking in general and that they considered them particularly attractive at that point in time. They also believed that biotechnology had great potential, as did China, and wanted my opinion about investing in all these areas. They were concerned that inflation was going to increase over time. Our discussion on tolerance for risk was a little more difficult. Dan was fairly conser- vative, saying they didn’t have enough money and couldn’t afford to lose it. He was concerned over the fluctuations in the current prices of stocks, preferring a mix of 40 percent in stocks and 60 percent in bonds. Laura, on the other hand, said that investing represented a terrific opportunity for those willing to take it. If they lost money, they had plenty of time to make it up. She wanted 80 percent in stocks and 20 percent in bonds. She said Dan was always concerned over the current price of a stock. He replied that she was always optimistic. After discussion among the three of us—I had the feeling that we all knew what the outcome would be at the beginning of the conversation—we decided on a 60 percent stock, 40 percent bond mix. They had their own economic scenario with normal economic growth but believed that higher inflation than generally expected would arrive fairly soon. They knew that I was a fi- nancial planner who provided ongoing investment management services and asked for some information on how I would manage their money. However, they wanted to maintain control of their assets until the financial plan was completed before deciding on investment manage- ment services. In the meantime, they would implement the recommendations I gave to them.

Here’s my response: We are up to the investments portion of the financial plan. I am going to incorporate in it most of the basics of an investment policy statement for both of you as part of the presenta- tion. The investment policy statement serves as a guide for the management of your port- folio. This statement, which I will present informally, includes many of the steps in my asset allocation process for you. It ensures that we are “on the same page” as to your per- sonal requirements and our investment approach for you going forward. Before we do that, however, I want to review some overall capital market variables. The first is that the outlook for stocks and bonds is strongly influenced by risk and return: In general, the higher the risk, the higher the return. For some, it indicates that most securities at any point in time are efficient; their current prices fairly reflect the outlook. For exam- ple, if it looks to you as though a bond had a very attractive yield and therefore high cash return, chances are it is because it has a higher risk attached to it. On the other hand, other people believe in mean reversion. Those people, many of whom have a value-oriented style of investing, buy out-of-favor stocks that are “bargains.” They have the conviction that a disciplined person can take advantage of the temporary mispricing of securities. Mean reversion implies that stocks that are temporarily selling for a lower price than they should will return to their fair value over time.

292 Part Three Portfolio Management

There are, of course, other styles of investing that attempt to take advantage of what are thought to be opportunities in individual securities or even the overall market at certain points in time. One, purchasing the fastest-growing companies available, is called the growth style of investing. There is a significant difference between efficient markets and mean reversion and between value and growth investing. Efficient market people believe you cannot consistently outperform the market; they prefer a passive approach to investing. They emphasize keeping expenses low and concentrating on proper diversification to reduce risk. Efficient market people generally use index funds to implement their investment strategy. People who employ mean reversion, one form of value investing, generally believe that strong research and control over emotional reactions can lead to better- than-average returns. This brings us to your asset allocation and my investment policy statement for you. You have several goals that we deal with in other parts of the plan, but your overriding goal for our purposes today is your desire to retire in 20 years. Thus, your time frame is longer term. Liquidity is not as large an issue for you, as we have stated, but not for the retirement monies already accumulated and to be invested in the future. We will be setting aside an emergency fund over time. In the interim, as you have indicated to me earlier, you can bor- row from Laura’s parents for any emergency. You seek above-average returns and your risk tolerance, while somewhat different for each of you, is nonetheless consistent with that objective. In other words, your risk–return objectives are in line. We will be thinking of tax consequences as part of our investment policy. For example, given their higher after-tax returns, tax-free municipal bonds of your state are likely to be used. Some people have restrictions on types of stocks, such as not allowing tobacco stocks, but you have not indicated any such requirement. For the time being, we will limit purchases to mutual funds. Mutual funds, in my opin- ion, provide the best balance of capable management and relatively low cost. They allow anyone to diversify widely in order to reduce risk and to take advantage of fund manager expertise in specific sectors of the bond and stock markets. We will employ an active approach to portfolio management. By portfolio management, we mean looking at your financial assets overall, making sure that they fit your return and risk requirements as represented by your asset allocation. Our approach of diversifying widely can handle the sometimes overlooked part of supervision—correlation. Correlation indicates the relationship between assets, the degree to which they react similarly to the same variables. All other things being equal, the lower the correlation, the lower the portfolio risks. For example, investments in Japanese stocks are going to be less correlated with U.S. ones than one large-sized economically sensitive U.S. industry is with another—say, retail stores and appliance stocks. I employ a diversified style of investing, but with a value tilt. I base the portfolio on a longer-term investment horizon. An asset allocation provides the average weighting of securities by category in the portfolio over time. The average percentage weightings over the longer term are called a strategic asset allocation. I do not try to time the market. I do attempt to take advantage of disparities in valuations at the present time. In other words, I try to moderately overweight those areas that appear to be attractive at the present time. For example, in the third column of the table I’m presenting to you I have overweighted international stocks because they seem to be fairly priced and provide attractive returns. On the other hand, I have underweighted REITs (that represent your real estate holdings), which, in my opinion, are overvalued at the moment. Unlike timing the market, which implies turnover for short-term profit, this approach expects that over the intermediate or longer term, our overemphasis of certain areas will lead to higher

Chapter Ten Financial Investments 293

returns. I call the portfolio breakdown that I have placed in the third column our tactical asset allocation. Based on those principles and an overall economic scenario, I have constructed your strategic and tactical asset allocations. They are shown in the accompanying table. Notice the wide diversity of asset classes in both stocks and bonds. In bonds they range in risk from short-term bonds, being the safest, to high-yield bonds, the most risky. Similarly, for stocks they extend from larger capitalization companies, which have the least risk and lowest expected return, to small capitalization companies, with the greatest risk and highest potential return. Notice also that I have included an allocation in interna- tional securities. Part of that allocation includes an investment in a China fund; I believe the securities in this fund to be reasonably priced currently relative to prospects. International securities have the potential to lower your portfolio’s overall volatility, even if they themselves are more volatile. Based on our discussions, I have provided a breakdown of a diversified portfolio of 60 percent stocks, and 40 percent bonds and money market funds. It stands in contrast to your current portfolio, which has 75 percent concentrated in large cap stocks and the rest in cash. The long-term bond area has not been given an allocation because, historically, inter- mediate-term bonds over longer periods have provided about the same returns but with lower risk. In view of your concern about inflation, I have placed more money in the short-term area and underweighted intermediate-term bonds in the tactical allocation. This allocation is more oriented to the current outlook. Shorter-term bonds will be affected less than inter- mediate ones in any rise in inflation. My recommendations will come in the form of mutual funds. I believe that funds offer an attractive alternative of expert management and ability to diversify widely. In sum, I have provided a diversified portfolio of investment that should assist you in achieving sufficient funds to meet your life cycle needs.

Asset Category Current

Allocation Strategic

Allocation Tactical

Allocation Standard Deviation

10 Year38


Small cap – 10% 14% 19.6 Mid cap – 8% 10% 18.1 Large cap 75% 20% 18% 15.6 International – 17% 20% 19.6 Real estate funds39 – 5% 3% 23.5 Total Stock 75% 60% 65% 18.4


Short term – 10% 15% 2.0 Intermediate – 15% 8% 3.5 Long term – 5% 0% 10.0 High yield – 5% 7% 9.5 Total Bond 0% 35% 30% 4.2

Money market 25% 5% 5% 0.5 Total 100% 100% 100% 13.3

38 10-year data from Morningstar® Office® for the period November 11, 2004, through November 11, 2014. © [2014] Morningstar, Inc. All rights reserved. The information contained herein: (1) is proprietary to Morningstar and/or its content providers; (2) may not be copied or distributed; (3) does not constitute investment advice offered by Morningstar; and (4) is not warranted to be accurate, complete, or timely. Neither Morningstar nor its content providers are responsible for any damages or losses arising from any use of this information. Past performance is no guarantee of future results. Use of information from Morningstar does not necessarily constitute agreement by Morningstar, Inc., of any investment philosophy or strategy presented in this publication. 39 Includes traditional real estate funds and REIT funds.

294 Part Three Portfolio Management

College Student Case Study and Review: Amy and John FINANCIAL INVESTMENTS Amy and John arrived early for our meeting because Amy was anticipating this discussion. She knew very little about investments and had some money left to her by her grandfather. She said today’s topic, financial investments, was “news she could use today.” John joked that though his stepsister was extremely bright, she was so inexperienced in investments she thought common stock were cattle from a ranch in Texas. I interjected telling John to let Amy express herself. Amy proposed that we treat the topic as an investment plan for her $20,000 inheritance. Such a plan would summarize the components of financial investments and apply it step- by-step to her money. I explained to her that investments aren’t meant to be built up forever but to be accumu- lated for use for a specific purpose with the most common strategic use to help fund retirement. Asset allocation is how much is put in each category of assets, with stocks and bonds being the most typical category. As she requested, I presented the information step-by-step.

A. Establish Goals How you invest the money depends on what you want to do with it. Amy quickly said her grandfather had wanted the inheritance to be used as a down payment on a home, and that she would honor that request, probably within the next 10 years.

B. Consider Personal Factors Each individual has certain personal characteristics shaping his or her goals. For example:

1. The length of the investment period as determined by the time until the money will be spent.

2. Liquidity needs—the need or ability to convert the investment into cash.

3. Current available resources—what you have available.

4. Projected future resources—how much your resources are projected to grow based on anticipated future cash flow, and savings and investment return on that cash flow. Both can help determine the amount of risk you should take.

5. Taxes—the percentage the government will take of future cash flows influences the type of investment.

6. Restrictions—practical or behavioral limitations on the type of investments.

7. Risk tolerance—an overall limitation on risk taken, based on factors such as personality and resources.

Amy said, “I can answer those questions. I won’t buy a home until I get married. I don’t expect that to happen for 10 or more years. My parents are likely to give me money to support me in case of an emergency. I already have $20,000 in resources. One of my concerns is that if I keep the money in the bank I’ll spend it down over time on things I don’t really need. If I put it in a separate investment account and purchase stocks and bonds I am not likely to touch that money.” “I don’t expect to have further savings until I graduate and find a job but that shouldn’t be too long from now. I expect to start working in about 1½ years, after a two-month trip across Europe, which will be a promised graduation present from my mom and dad.” “My tax bracket should be low, the fashion industry trades off low salaries against glamor. I have no restrictions against investment asset classes. My risk tolerance is high. I expect to have a long life and successful career and if I lose it all at this age, I’ll just work harder.”

Chapter Ten Financial Investments 295

John and I looked at each other in amazement. It was clear that Amy had thought about and knew more than we had believed. I made a mental note that good things happen when people are interested in and motivated by a topic. Altogether, Amy’s responses indicated that she could hold a broad range of asset classes, with an allocation skewed toward vola- tile holdings such as equities. Accordingly, I proceeded with my presentation.

C. Include Capital Market Factors The most basic rule in investments, in theory and often in practice, is that prices for growth come from two variables, risk and return. Basically the higher the risk the higher the ex- pected return; if an investment has higher risk why would anyone buy it without the expec- tation of higher return? Generally, risk and return move proportionally higher together. The Capital Asset Pricing Model (CAPM) as an investment theory is based on risk and return. Risk is divided into systematic risk, the risk coming from the overall market and unsystematic risk, the chance for loss arising from the specific asset. In a large portfolio, unsystematic risk is diversified away (disappears) because worse than expected losses for some stocks are offset by other holdings with better than expected results. The remaining risk is identified by the beta coefficient, which is the movement in an individual holding or the entire portfolio as compared with an appropriate overall stock market index such as the S&P 500 or the Dow Jones Industrial Average. The overall index has a beta of one, lower-risk stocks have a beta below one, higher-risk ones above one. An alternative measure of risk is the standard deviation. It measures the amount of price fluctuation around the investment’s average price; therefore, unlike the beta, which is lim- ited to systematic risk, it measures the entire risk of the asset or portfolio. Both measures have the advantage of providing an objective measure of risk based solely on asset or port- folio price fluctuations instead of people’s opinions. Under CAPM the expected rate of return is equal to the risk-free rate, often the yield on a short-term Treasury bill, plus a risk premium. Each stock has its own risk premium and investors demand that the risk premium be higher for those securities that have higher risk, or as I mentioned they won’t buy it. The efficient market hypothesis (EMH)* is another part of modern investment theory. It says that all prices for investments already include all available information, and whether new information will be positive or negative news cannot be predicted in advance. This new information is rapidly built into the price of the shares. In other words, according to this theory don’t try to select stocks or mutual funds that outperform the market, you’re wasting your time and money. Buy mutual funds or exchange traded funds (ETFs) with razor thin costs that attempt to duplicate the market’s performance. John asked how EMH theory has done in practice. The answer is mixed: most investors have trouble outperforming the market, but tests show that it is possible, particularly for secu- rities about which people are extremely negative. An example would be those that are priced cheaply relative to their earnings. Another theory called mean reversion may be considered. It says that EMH works out over long periods of time; as stocks are stretched over the longer term, prices in the marketplace become what they should be. Mean reversion provides more hope that people can benefit from getting an edge in selecting cheap stocks by analyzing them carefully and thinking independently. Amy said thinking independently and buying when stocks were cheap was her type of approach. Then Amy glanced at John, who rewarded her with a smile of approval.

D. Identify and Review Investment Alternatives We discussed which investments would be suitable for Amy. I mentioned I thought they come down to individual stocks, bonds, and mutual funds. Bonds, I mentioned, were contracts

*See Appendix I for information on efficient markets and mean reversion.

296 Part Three Portfolio Management

between the lender and the borrower with the borrower agreeing to pay interest annually, generally at a fixed rate, and to repay the amount lent at the maturity date. With all elements generally in place contractually, bonds in many respects are safer than stocks. Common stocks, also called equities, are risker because they represent ownership, not lend- ing as in the case of bonds. When business operations work out well you can make a great deal of money; when they do not, you can lose part or all of your investment. Stocks vary by such factors as the sector of the economy and industry they operate in, their geographic area (domestic or international), the size and quality of the company, and their relative growth rates. Mutual funds are organizations that invest in stocks and/or bonds. They offer the expertise of professional managers and wide diversification of investments with professional record keeping and general information, all at relatively low cost. They can do so because of econ- omies of scale as all investors’ monies are integrated for common purchase, but maintaining separate share ownership in the fund with record keeping included at no extra charge. Mutual funds vary by many of the same characteristics as stocks and bonds. There are three size categories: small, mid, and large cap. For stocks they are generally separated by size and style. Size can be small cap as in your local steakhouse with five locations having a public offering so they can keep growing to, say, IBM, a large cap company with mid cap somewhere in between as measured by stock market value. The style of investing categories include growth, blend, and value. Growth managers buy the higher quality, faster growing companies. Value managers place more emphasis on price, purchasing companies that are cheap relative to fundamentals. Blend is in between or employs a different style altogether. John volunteered that he liked the value style because it reminded him of the way he purchased other products, which was to find quality goods at the cheapest prices available. I agreed with John that while growth and value vary in popu- larity and performance, over long periods of time value may exceed growth in results. Herd instincts and lack of patience for long-term vision attribute to the popularity of growth funds. Critical thinking investors can analyze and take advantage of relative degrees of over- or undervaluation over time by investing in value funds.

E. Evaluate Specific Investment Considerations I wanted Amy and John to evaluate two choices. The first choice was whether they were going to adhere to the efficient markets hypothesis and take a passive approach to investing or select an active approach and attempt to outperform the market. The second choice was whether to select individual securities or mutual funds. Amy once again said she wanted an active approach to investing, saying it fit her personality to try to get the best, not the almost guaranteed mediocre performance from a passive approach. She thought that mutual funds were right for her because she had neither the time nor the interest to select individual stocks. John generally agreed, although he said he would maintain the right to put a small portion of his portfolio in more specialized stocks that had the potential to “become another Apple.” We then discussed how to select mutual funds. An entire system has been developed including:

1. The goal of the funds and other descriptive information.

2. The investor’s preferred size and style.

3. The portfolio’s performance relative to other funds in the same category.

4. The portfolio’s risk.

5. How consistent past performance has been.

6. How long the portfolio manager has been there.

7. The fund’s size.

8. Its overhead costs called the expense ratio.

Chapter Ten Financial Investments 297

The alternative I would consider is looking at a Morningstar sheet for the fund. In basic form it is available free online. That company is the originator of the concept of classifying a stock fund by its investment style and the size of the companies it holds.

F. Employ Portfolio Management Principles Our discussions to date have been about individual holdings. Yet what we end up with is a portfolio of assets. The portfolio has its own characteristics including an overall growth rate and a measure of overall risk. But there is another factor that enters. Most everyone knows that people should diversify their investments. Many don’t know that their investments are likely correlated with each other, meaning that to some extent they move together when relevant events happen. The degree to which they move together is measured by the corre- lation coefficient with a low correlation, say 0.10, being generally more desirable than a high one of 0.95. A low correlation among assets at the time of a negative event can mean an anchor against a sharp decline in asset valuation for one segment of the portfolio. Assets with negative correlation to one another are even better, but are harder to find. While we are on this topic you should embrace some of the TPM® principles that we discussed in earlier meetings. Keep in mind that all assets and liabilities will enter into your household portfolio once you graduate and are working. It would include not only financial assets but human assets, human-related assets, and real estate assets. For example John, if you do become a financial planner, the firm you work for will generate part or all of its revenues from asset management fees on stocks and bonds. You should consider placing above-average emphasis on other assets such as real estate. Otherwise your career, a human asset, and financial assets may be too highly correlated with each other. For the moment, with each of you as undergraduate students living at home and not set on your ultimate careers, I believe we can make decisions based on financial assets alone.

G. Implement Portfolio Management Decisions I mentioned to John and Amy that it was time to review all of the key steps in establishing their financial portfolio:

• Active versus passive investment style. You have decided on an active investment style that will require more asset review and some buys and sells over time.

• Construct a strategic asset allocation. A strategic allocation is your long-term break- down of assets in your portfolio. It is the allocation that you return to after particular circumstances, such as preparing for the possibility of a recession, have cleared up.

Both Amy and John mentioned that they were young and wanted to take above-average risk. They decided on a portfolio of 75% stocks and 25% bonds. Amy chose to put everth- ing in mutual funds and John put all but 5% in mutual funds with that modest amount placed in stocks with above-average risk.

H. Develop a Tactical Allocation A tactical allocation is one that deals with the realities at the present time. Two very impor- tant areas are the outlook for the economy and the stock market, and how components have been faring. I decided to provide them with some overall information from my perspective. I thought the economy would grow nicely over the next several years, and larger companies in the United States and abroad would do particularly well. I believed that interest rates, now down sharply from their norms, would rise gradually making existing holders of bonds subject to low returns relative to historical figures. Each decided to overweight in stocks, particularly large caps, and to underweight inter- mediate and longer-term bonds, which I said could be most hurt by a rise in interest rates.

298 Part Three Portfolio Management

I. Finalize and Implement the Portfolio The next step for Amy was to select and finalize the individual investments under each of the categories listed. John had little money to invest and I thought would go for high fliers, midway between risky legitimate stocks and Las Vegas gambles. I wanted to mention to Amy to not neglect correlation coefficient in her search for individual holdings. However, I decided she had investment information overload and passed on it for another time.

Summary Financial investments are generally the instruments for building assets for your future use. Without them, you would have difficulty funding those things you care about.

• Financial assets consist primarily of stocks, bonds, and mutual funds.

• Having an appropriate asset allocation is the goal of most investors.


Asset Category Strategic Asset

Allocation Tactical Asset

Allocation Explanation

Small cap 15% 12% Valuations too high Mid cap 7% 5% Outperformance will lead

to mean reversion Large cap 28% 31% The best domestic

outlook International 20% 22% Faster growth than U.S. REIT 5% 5%

Total Stocks 75% 75%


Asset Category Strategic Asset

Allocation Tactical Asset

Allocation Explanation

Short term 4% 8% Hedge against rising rates Intermediate 8% 4% Adversely affected by

rising rates Long term 4% 1% Adversely affected by

rising rates Inflation indexed 3% 3% High yield 3% 4% Stronger economy results

in more confidence in low quality bonds

Total Bonds 22% 20%

Money Market

Asset Category Strategic Asset

Allocation Tactical Asset

Allocation Explanation

Money market 3% 5% Hedge against rising rates

Total 100% 100%

Chapter Ten Financial Investments 299

• Important personal factors in asset allocations include time horizon, liquidity needs, avail- able current resources, projected future resources, taxes, restrictions, and risk tolerance.

• Risk and return are basic finance concepts. In theory, the two factors move in proportion.

• A security’s expected rate of return includes the risk-free rate plus a risk premium.

• The efficient market hypothesis indicates that efforts to systematically outperform the market will be unsuccessful.

• Mean reversion indicates that there may be patterns in stocks that can lead to outperformance.

• Portfolio management looks at all financial investments overall in making decisions, and the Markowitz approach includes correlations among them.

• Total portfolio management incorporates all assets and liabilities and includes correla- tions in its risk–return framework.

• A strategic asset allocation looks at investment policy over the long term, while a tacti- cal one makes cyclical changes based on opportunities at the time.

Key Terms active approach to investing, 278 asset allocation, 267 blue chips, 274 bonds, 273 correlation coefficient, 279 cyclical stocks, 274 defensive stocks, 274 efficient market hypothesis (EMH), 295

growth stocks, 274 growth style of investing, 276 index fund, 277 insurance risk, 266 investment risk, 266 maturity date, 273 mean reversion, 278 mutual fund, 274 passive approach to investing, 277

portfolio, 279 risk premium, 295 risk tolerance, 269 speculative investments, 274 systematic risk, 295 unsystematic risk, 295 value style, 276

finance.yahoo.com Yahoo’s Finance Portal This site provides a wide array of financial information for students and beginning investors. It presents key statistics, financial statements, analyst opinions, news and charts for the majority of U.S. and world market stocks, mutual funds, ETF, indices, and options. It also contains links to a number of topics in investing and personal finance.

naip.com National Association of Investment Professionals This organization provides information geared to the interests and needs of individu- als working in the financial services industry. The site has links to resources of secu- rities laws, rules, and regulation information. It covers topical information for investment professionals.

investopedia.com Investing Glossary Information for students and beginners in the finance field. The site contains a rich dictionary with finance term definitions, explanatory tutorials, useful articles, finance exam information, and tools such as financial calculators and free trading kits.


300 Part Three Portfolio Management

investorguide.com Investor Information While the previous website is more educational, this site offers current market infor- mation, quotes and charts, news and comments, and research company information. It also has a glossary of finance terms.

Websites of U.S. and world stock exchanges include

nyse.com NYSE Euronext This is the website for the multiple exchanges, including the New York Stock Exchange, NYSE Euronext, NYSE Amex, and NYSE Arca.

nasdaq.com NASDAQ

tse.or.jp/english Tokyo Stock Exchange

londonstockexchange.com London Stock Exchange

1. Explain why under CAPM company risk can be diversified away.

2. Under the EMH, can you outperform the market?

3. Under the weak form of the EMH, if you are given the following recent day price performance:


Day 2 Days Ago The Day before Yesterday Yesterday Today

Price 6 7 8 9

is the likely future performance higher than nine? Why?

4. Under the semistrong form of the EMH, should you read an annual report? Why?

5. Investing abroad has substantial individual asset risk. Why invest in it then?

6. Why can real estate be an attractive portfolio holding?

7. What are the strengths of mutual funds?

8. What are the weaknesses of mutual funds?

9. What types of investments are most appropriate for short-term needs?

10. What kinds of investments are best suited to saving for the down payment on a house to be made in three years?

11. What types of investments are suited to retirement planning at age 67 assuming the person is 55 and has an average risk tolerance?

12. What are the advantages of a passive approach to investing?

13. How has mutual fund performance compared with overall indexes? Why do you think that is the case?

14. How are income taxes determined for mutual funds?

15. Stock A and stock B have no correlation. Does that mean we don’t have to include correlation in calculating portfolio return? Explain.

16. Stocks C and D move in opposite directions. Does that mean they have no correlation? Explain.

Chapter Ten Financial Investments 301

Problems Gennaro purchased a stock for $24 that paid $2.00 at the end of each year in dividends (dividends remained level over time). He sold it four years later for $28 at the time of the last dividend payment. What was his IRR?

A stock has an expected rate of return of 9 percent and the risk-free rate is 3 percent. What is the risk premium?



“Stock prices adjust rapidly to the release of all new public information.” This statement is an expression of which one of the following ideas?

a. Random walk hypothesis.

b. Arbitrage pricing theory

c. Semistrong form of the EMH

d. Technical analysis

If the client needs to accumulate wealth but is risk-averse, which of the following is the most crucial action the planner must take to have the client achieve the goal of wealth accumulation? Advise investing the client’s current assets

a. In the products that will bring the highest return to the client regardless of risk.

b. In products that produce high income for the client because fixed-income products are generally safe.

c. In diversified mutual funds because of the protection that diversity provides.

d. After determining the client’s risk tolerance.

e. In 100 percent cash equivalents in the portfolio because most software programs recom- mend this safe approach.

If the market risk premium were to increase, the value of common stock (everything else being equal) would

a. Not change because this does not affect stock values.

b. Increase in order to compensate the investor for increased risk.

c. Increase due to higher risk-free rates.

d. Decrease in order to compensate the investor for increased risk.

e. Decrease due to lower risk-free rates.

Which of the following are nondiversifiable risks?

1. Business risk.

2. Management risk.

3. Company or industry risk.

4. Market risk.

5. Interest rate risk.

6. Purchasing power risk.

a. 1 and 3 only

b. 1 and 4 only.

c. 2 and 4 only.

d. 4 only.

e. 1, 2, and 4 only.





CFP® Certification Examination Questions and Problems

302 Part Three Portfolio Management

Modern “asset allocation” is based upon the model developed by Harry Markowitz. Which of the following statements is/are correctly identified with this model?

1. The risk, return, and covariance of assets are important input variables in creating portfolios.

2. Negatively correlated assets are necessary to reduce the risk of portfolios.

3. In creating a portfolio, diversifying across asset type (e.g., stocks and bonds) is less ef- fective than diversifying within an asset type.

4. The efficient frontier is relatively insensitive to the input variable.

a. 1 and 2 only.

b. 1, 2, and 3 only.

c. 1 only.

d. 2 and 4 only.

e. 1, 2, and 4 only.

A client has a $1,200,000 portfolio consisting of the following four stocks:

1. $300,000 ABC @ 1.1 beta.

2. $225,000 RTR @ 0.7 beta.

3. $405,000 XYZ @ 0.3 beta.

4. $270,000 PDQ @ 1.3 beta.

What is the beta of the portfolio as a whole?

a. 0.8.

b. 0.85.

c. 0.91.

d. 1.0.

A young, single client approaches a CFP® professional with $5,000 stating that he would like to develop a financial plan and invest in the market. This is his first experience invest- ing and he like help choosing he appropriate account. What is the CFP® professional’s most appropriate course of action?

a. Open a brokerage account with margin.

b. Open and fund a Roth IRA for the current year.

c. Determine whether the client has any consumer debt.

d. Determine whether the client has adequate life insurance.




Chapter Ten Financial Investments 303

Case Application FINANCIAL INVESTMENTS When it came to investments, Richard and Monica could agree on only one thing—that they would have a tough time reaching a decision on asset allocations and individual investments. Previously, Monica had deferred to Richard on investment matters. Given Richard’s large recent investment loss, however, Monica was much more forceful in expressing her feelings. She thought that a 40 percent stock, 60 percent bond allocation fit, particularly given the lower level of accumulated wealth they now had. Richard, on the other hand, wanted 100 percent of the funds placed in stocks. He asked if it wasn’t true that stocks always did better than bonds over the longer term. He said that to reach their goals, they needed some aggressive investments. Monica interrupted, saying it was just that “stocks-had-no-long-term-risk” mentality Richard had that led to their invest- ment losses. Richard then volunteered that there was an oil stock, “Energy Gulch,” a friend of his recommended that “couldn’t lose.” He wanted to place 20 percent of his money in it.

Case Application Questions 1. What do you think of the Richard and Monica argument?

2. Using the asset allocation alternatives listed in this chapter as a guide, what should their asset allocation be? Why?

3. What do you think of the Energy Gulch idea? Why?

4. Select one mutual fund you find attractive and give the reasons why you chose it.

5. Complete the investments section of the financial plan.

Appendix I

Modern Portfolio Theory This appendix will distill many of the key points pertaining to modern portfolio theory, and the capital asset pricing model, the leading approach taught in financial courses. The capital asset pricing model (CAPM) is a specialized modern investment theory model that is based on risk-return principles. Its risk is received by measuring price change of a security relative to a benchmark’s price performance. The benchmark for large company stocks is usually the S&P 500, the Standard and Poor’s index of the 500 largest companies in the United States. The risk measurement is called the beta coefficient and the higher the price fluctuation of a security relative to the benchmark’s movements, the higher the security’s beta coefficient. The benchmark is automatically given a beta of 1 and stocks or mutual funds of stocks having a beta coefficient higher than 1.0 are deemed to have more risk than the market, while those having a beta less than 1.0 have below-average risk. Unlike the standard deviation, the beta coefficient doesn’t claim to measure total risk, just systematic risk. Systematic risk is the risk of overall market factors such as the econ- omy, inflation, interest rates, and the stock market. In contrast, unsystematic risk is risk related to an individual company such as a decline in market share, the loss of a key patent,

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and so on. CAPM says individual company risk can be diversified away when you hold a large portfolio of securities. Therefore, CAPM says that all you need to know is systematic risk as measured by the beta coefficient. The standard deviation and the beta coefficient have a strong advantage. Unlike funda- mental measures of risk, they both can be measured objectively. For each measure, the higher the figure, the higher the risk. In most instances, beta coefficients and standard de- viations are developed by independent investment services such as Morningstar and Value Line, and their newsletters are available in many libraries. As a practical matter, all you need to remember is that a beta higher than 1.0 equals above-average risk; a beta below 1.0 equals below-average risk.40 Also keep in mind that both the beta and the standard deviation are best used when comparing securities that are similar to each other. For a more detailed explanation of beta coefficients, see Web Appendix A: Modern Investment Theory.

Example 10.A1.1 Dana was down to one of two choices of investments in her pension plan at work. She wanted growth of assets, was fairly aggressive in her investment tolerance for risk, and, therefore, chose from stock, not bond, mutual funds. She went to the library and found results for her pension plan’s two stock alternatives. The first fund, the Oaktimber Fund, had a beta coefficient of 0.75 and a standard deviation of 15.8. The second, the Advanced Horizon Fund, had a beta of 1.54 and a standard deviation of 31.2. Both mutual funds invested in large companies. She looked up an S&P 500 index fund that had statistics very close to those of the actual index and found its beta to be 1.0, as she thought. She knew that the S&P was the benchmark of large company performance and 1.0 meant average. She also found out that the S&P 500 had a standard deviation of 21.0 for the past period being measured. Dana instantly recognized that the beta coefficient of 1.54 for Advanced Horizon was well above the market, signifying higher-than-average risk. The standard deviation also was sub- stantially above the market’s 21.0. She also noticed that Advanced Horizon’s three-year return of 13 percent a year was well above Oaktimber’s 9 percent a year. She thought to herself, the higher the risk, the higher the return. She picked Advanced Horizon, which best fit her high risk tolerance.

EXPECTED RATE OF RETURN Under modern investment theory, the expected rate of return combines risk–return princi- ples to arrive at a projected future return. As the equation below indicates, the expected rate of return is equal to the risk-free rate plus a risk premium. Therefore, the risk premium is the extra return that compensates you for the additional amount of risk you are taking with a particular security over a completely safe one.

Risk-Free Rate and Risk Premium The risk-free rate, the completely safe one, is the rate of return you require even if there is no risk. The yield on 30-day U.S. government Treasury bills is generally used to gauge this rate.41

The risk premium depends on the degree of risk undertaken. For example, a nearly bankrupt airline will have a much higher risk premium than a leading high-quality food company.42

40 Relative to its benchmark. 41 Some would say 90-day or 10-year government issues are more appropriate depending on the time horizon for the investment. 42 The investor may use either the standard deviation, the beta coefficient, or more judgmental factors as inputs in establishing the risk premium.

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The risk-return characteristics of various securities are demonstrated in Figure 10.A1.1. Notice that the risk-free rate appears right on the expected return line. That is because it is viewed as having no risk. The diagram shows that the more risky the security, the higher the risk premium and the higher the expected or required rate of return.43

Example 10.A1.2 Brad had two investments: one in government bonds, the other in a speculative stock fund. Over a five-year period, he received an average return of 5 percent a year in government bonds and 5.5 percent for the speculative fund. Brad thought to himself that he made more money in the stock than the bond. Yet he was dissatisfied with his stock performance. He felt he should have received higher return for the risk taken. In other words, his risk premium should have been more than 0.5 percent a year.

THE EFFICIENT MARKET HYPOTHESIS The efficient market hypothesis is one of the basic assumptions of a pure risk–return approach. When risk and return are exactly correlated, all investments sell at the prices they are expected to. As you can gather, the efficient market hypothesis (EMH) deals with investment information and valuation of individual securities. It says that the best valuation for an individual security is its current market price. This price reflects all information known about the security. It is the fair price for the asset. When new information is issued, it is quickly incorporated in the price of the shares. A major conclusion of the EMH is that it will not be profitable to attempt to outperform the market. Even if there were people who were not fully informed or capable of apprais- ing shares, and their actions could create particularly appealing prices, other investors would quickly step in to take advantage. By doing so, these investors would eliminate any above-average profit opportunities.

Example 10.A1.3 Suppose a market analyst disclosed that, according to his tests, the length of women’s skirts was an indicator of the future direction of the market. Actually, there reputedly was such a theory some 75 years ago. Suppose that buying stocks when skirt lengths rose and selling them when they dropped resulted in a doubling in investment returns. This information would

43 For our purposes, expected and required rates of return are synonymous.

Expected Return

Risk-free rate


Government bonds

High-quality stocks

Corporate bonds

Speculative stocks

Security market line

FIGURE 10.A1.1 Security Market Line

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spread quickly. The next step would be market analysts, portfolio managers, and television commentators positioned at the fashion openings of prominent designers to observe leading- edge fashion lengths. As soon as the new skirt lengths were known, the investors would communicate orders via cell phone directly to the floor of the stock exchange and via television to all viewers. This information, now known by all who would try to act on it, would be instantaneously incorpo- rated in stock prices. Knowledge of skirt lengths would no longer have investment use. The price of all shares would be efficient in that it would reflect all available information including the length of women’s skirts.

There are three forms of the EMH: the weak form, the semistrong form, and the strong form.

• The weak form. The weak form deals only with price and volume for a security. It says that looking at current and past information on stock price patterns and the number of shares traded will not be useful.

• The semistrong form. The semistrong form states that all publicly available information is incorporated in a stock’s price. Therefore, not only information on price and volume but also fundamental analysis such as analysis of annual reports, brokerage firm recom- mendations, discussions with industry and company representatives, and so on, will not lead to better-than-average performance.

• The strong form. The strong form states that the share prices fully reflect not only pub- lic but also private information. Therefore, knowledge of information on a company’s outlook that has not yet been released to the public or other insider information is not useful.

In effect, the weak form says that technical analysis has no use. That is because tech- nical analysts use just price changes and volume to make predictions about future per- formance. If the weak form of EMH is true, then technical analysts are wasting their time. Some tests of this hypothesis have turned up anomalies—exceptions to efficient market beliefs and opportunities to use technical analysis for extra profit.44 The strong form has not been tested as often,45 perhaps because intuitively it does not seem logical that knowledge of what is going on inside a company before others know it would not be profitable. Most tests of the EMH have focused on the semistrong form and public information. It not only includes the weak form’s technical analysis it also extends efficiency to include all public information. It isn’t as broad as the strong form because it doesn’t include private information. Contrary to efficient market theory, a relatively broad array of opportunities for profitable investing has been found including purchasing depressed stocks early in

44 David P. Brown and Robert H. Jennings, “On Technical Analysis,” Review of Financial Studies 2, no. 4 (October 1989); and Yufeng Han, University of Colorado at Denver, Ke Yang, Washington University in St. Louis, and Guofu Zhou, Washington University in St. Louis, “A New Anomaly: The Cross-Sectional Profitability of Technical Analysis,” 2010, apps.olin.wustl.edu/MEGConference/Files/ pdf/2010/49.pdf 45 See Jeffrey F. Jaffe, “Special Information and Insider Trading,” Journal of Business (July 1974): 410–28; Nejat H. Seyhun, “Insiders’ Profits, Costs of Trading and Market Efficiency,” Journal of Financial Economics 16 (1986): 189–212; Lisa K. Meulbroek, “An Empirical Analysis of Illegal Insider Trading,” Journal of Finance 47, no. 5 (December 1992): 1661–99; and Utpal Bhattacharya, Department of Finance, Kelley School of Business, Indiana University, “Insider Trading Controversies: A Literature Review,” 2013, papers.ssrn.com/sol3/papers.cfm?abstract_id=2340518.

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January,46 small cap stocks,47 those with low price to book,48 and those with low P/E multiples;49 eliminating or shorting those with high P/E multiples;50 purchasing those that have been neglected;51 and so on.

Mean Reversion and Efficient Markets As mentioned in the chapter mean reversion,52 as it relates to groups of individual securi- ties or overall markets, says that returns for securities tend to move toward average perfor- mance when the returns are examined over longer time frames. Therefore, if securities underperform for a period, they may be more likely to outperform later on. When their results are highly favorable for a period of time, they can be vulnerable to poor returns in the period beyond. Thus, in contrast to efficient market beliefs, future stock price move- ments may be somewhat predictable.53

46 See Michael S. Rozeff and William R. Kinney Jr., “Capital Market Seasonality: The Case of Stock Returns,” Journal of Financial Economics 3, no. 4 (October 1976): 379–402; Marc R. Reinganum, “The Anatomy of a Stock Market Winner,” Financial Analysts Journal 44, no. 2 (March–April 1988): 272–84; and Kathryn E. Easterday, Miami University Farmer School of Business, Pradyot K. Sen, University of Washington Bothell, and Jens Stephan, University of Cincinnati—Department of Accounting, “The Persistence of the Small Firm/January Effect: Is it Consistent With Investors’ Learning and Arbitrage Efforts?,” 2008, http://papers.ssrn.com/sol3/papers.cfm?abstract_ id=1166149 47 Rolf Banz, “The Relationship between Return and Market Value of Common Stocks,” Journal of Financial Economics 9 (March 1981): 3–18; Marc R. Reinganum, “A Revival of the Small-Firm Effect,” Journal of Portfolio Management 18, no. 3 (Spring 1992): 55–62; and John B. McDermott, Ph.D., Fairfield University’s Dolan School of Business, and Dana D’Auria, Symmetry Partners LLC, “What Do We (Really) Know About U.S. Small-Cap Investing?,” ” Journal of Financial Planning,” January 2014, fpanet. org/journal/WhatDoWeReallyKnowAboutUSSmallCapInvesting/ 48 Barr Rosenberg, Kenneth Reid, and Ronald Lanstein, “Persuasive Evidence of Market Inefficiency,” Journal of Portfolio Management 11, no. 3 (Spring 1985): 9–17; Eugene F. Fama and Kenneth R. French, “The Cross Section of Expected Stock Returns,” Journal of Finance 47, no. 2 (June 1992): 427–65; and Stephen H. Penman, Columbia University—Department of Accounting, Scott A. Richardson, Wharton School, University of Pennsylvania, PA, and I

. rem Tuna, Wharton School, University of Pennsylvania, “The

Book-to-Price Effect in Stock Returns: Accounting for Leverage,” 2005, finance.wharton.upenn. edu/~rlwctr/papers/0505.pdf 49 Sanjoy Basu, “The Investment Performance of Common Stocks in Relation to Their Price-Earnings Ratios: A Test of the Efficient Market Hypothesis,” Journal of Finance 32, no. 3 (June 1977): 663–82 50 Ibid 51 Avner Arbel and Paul Strebel, “Pay Attention to Neglected Firms!” Journal of Portfolio Management 9, no. 2 (Winter 1983): 37–42; and Cem Demiroglu, Assistant Professor of Finance, Koc University, Istanbul, and Michael Ryngaert, Graham-Buffett Professor of Finance, University of Florida in Gainesville, “The First Analyst Coverage of Neglected Stocks,” Financial Management, Summer 2010, portal.ku.edu. tr/~cdemiroglu/initiation.pdf 52 See Werner DeBondt and Richard Thaler, “Does the Stock Market Overreact?” Journal of Finance 40 (1985): 793–805; James Poterba and Lawrence Summers, “Mean Reversion in Stock Prices: Evidence and Implications,” Journal of Financial Economics 22 (1988): 27–59; Eugene Fama and Kenneth French, “Business Conditions and Expected Returns on Stocks and Bonds,” Journal of Financial Economics 25 (November 1989): 23–49; and Daniel Mayost, Canadian Office of the Superintendent of Financial Institutions, “Evidence for Mean Reversion in Equity Prices,” 2012, osfi-bsif.gc.ca/eng/fi-if/rg-ro/gdn-ort/ pp-do/Pages/mnrv.aspx 53 Nicholas Barberis, “Investing for the Long Run When Returns Are Predictable,” Journal of Finance 55 (February 2000): 225–64; John Campbell and Robert Shiller, “Stock Prices, Earnings and Expected Dividends,” Journal of Finance 43 (July 1988): 661–76.

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Example 10.A1.4 Phil was interested in stocks in two industries: beverage companies and manufacturers of branded foods. They had the same beta coefficients. Over the past year, beverage companies had performed extremely well, rising more than the overall market, while food companies had actually declined in price. There was no fundamental news to account for the discrepancy in performance. Each industry’s earnings were in line with expectations. Phil believed that stocks and industries “come back” in price over time (reversion to mean performance) and chose to invest in the consumer food sector. Over the following year, he was rewarded with strong gains when their shares moved back to normal valuations, while the beverage companies underperformed the market. Over the combined two-year period before and after Phil’s analysis, both industries had the same average performance of 11 percent per year. Mean reversion had brought both industries back into parity.

Appendix II

Measuring Performance Performance should be measured both in selecting a mutual fund or a stock or a bond as well as in measuring our existing holdings’ results. For our purposes we will concen- trate principally on mutual funds; for a majority of people who have neither the time nor the inclination to follow stocks and bonds closely, investing in mutual funds is the appropriate choice. Performance for an investment should be measured on a risk-adjusted basis. That means including not only return for a period of time but the risk you took to obtain that return. If you bought a five-year bond in a nearly bankrupt airline that eventually repaid the debt and returned 5.5 percent a year, did you really outperform a 5 percent a year return available in a U.S. government bond? The answer from a risk-adjusted standpoint is no. Ask yourself if you would invest in a new issue by the same airline for a 0.5  percent extra return. Both the standard deviation and the beta coefficient measure risk—the standard devia- tion, total risk and the beta, and market risk relative to a market index. The Sharpe ratio, which is the return less the risk-free rate divided by the standard deviation, measures return per unit of risk. The higher the Sharpe ratio, the better the performance. The alpha coefficient provides actual return minus expected return, given market per- formance and the individual security or mutual fund’s beta coefficient. A positive alpha coefficient signifies market outperformance—the larger the alpha, the better the perfor- mance. A negative alpha coefficient signifies underperformance. The formulas and examples using these two performance measures are given in Part III of Web Appendix A. Figures for alpha coefficients and Sharpe ratios for mutual funds are available through publicly available mutual fund services such as Morningstar. Another method of measuring performance is comparing results for a fund with others like it. For example, a small cap value fund’s results are compared with other small cap value funds or a benchmark of that size and style. Given the variation in performance by size and style, this approach is used instead of comparing results with one generally recognized benchmark of performance for the market such as the S&P 500 or the Dow Jones Industrial Average. Some advisors use this approach exclu- sively; they assume that risk is taken care of by grouping investments into the same size and style grid.

Chapter Ten Financial Investments 309

Appendix III

Individual Fund Analysis The following are additional measures investors can take in analyzing funds. This informa- tion can be found via further research or with a subscription service such as Morningstar.

Look at the fund’s correlation coefficient. All other things being equal from an overall portfolio standpoint, the lower the correlation (R-squared) with the overall market, the more attractive the fund is. Identical price movements of a fund and the overall market index would result in an R-squared of 100.

Weigh the growth of assets in recent periods. Many times when a fund has outstanding performance, it receives media attention and a large inflow of cash. The higher cash can force it to purchase larger securities or less-attractive ones than those that produced the record. The result can be a regression toward mean performance and, in some cases, underperformance.

Look at tax efficiency. Observe whether a fund manager is concerned with taxes.


Chapter Eleven

Risk Management Chapter Goals

This chapter will enable you to:

• Evaluate risk management as an overall household approach.

• Distinguish the types of risk that people are exposed to.

• Demonstrate how risk modification leads to improved financial management.

• Analyze the central role insurance plays in reducing risk.

• Establish the common types of insurance available.

• Compare whole life and term insurance.

Dan and Laura indicated they were uncomfortable with their current overall risk profile. They felt they didn’t have enough insurance. They asked that all their assets be reviewed to make sure they weren’t exposed to potential losses. Dan said, “We want all of our assets protected against loss. Please examine our assets and tell us what changes need to be made.”

Real-Life Planning

The topic of risk management as we know it today did not exist 50 years ago. At that time, people and businesses were more concerned primarily with limiting their risks through the use of insurance. As businesses grew larger, their owners recognized that they were subject to a wide array of risks. Businesses not only had the risk of fire or stolen property to concern them. In addition, there was risk that raw materials’ prices would skyrocket or that their product line would meet more competition. There was risk of a sharp drop in the stock market. If they didn’t treat their employees well, there was risk of a strike or that valuable employees would leave. The more that businesses looked at it, the more they saw that they had to assess their risk overall. In effect, they had a portfolio of risks. It called for a central focus on the problem. Many of the more dynamic companies hired a risk manager. Instead of focusing principally on negotiating contracts with insurance carriers, this person, or, in larger firms, this department, concentrated on risks in many aspects of the company’s businesses. Risk managers’ responsi- bilities included safety practices and educational procedures for employees, and sometimes they were even given a voice in operating matters like limiting investing in buildings in less- developed countries. Their goal was to bring down losses in the company at a tolerable cost. At about the same time, the field of finance began to broaden considerably. The advent of computers enabled companies to better measure their risk financially. New financial instruments like options and swaps and more futures market alternatives added to the choices companies had to limit their risk.

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The field of risk management had come into its own. The professional society for risk managers changed its name from the American Society of Insurance Management to the Risk and Insurance Management Society, Inc., in 1975, and is now known as the Risk Management Society (RIMS). Occasionally, you may still hear people talk of risk management as the equivalent of insurance. However, an increasing number of people recognize that it is a far broader topic. Risk management can now be looked at overall as well as risk-by-risk. This risk management approach is also relevant to individuals and households. Obviously, it isn’t done in as sophisticated a way as it is in a large business, but the house- hold still needs to look at all types of risks and to use the tools that are available to deal with them. Our objective is to reduce the risk that negative events could result in the house- hold not meeting its goals.


The financial planning objective in risk management is to identify exposures that can create roadblocks to goal achievement or otherwise can be handled more effectively. People are often understandably nervous about the risks they encounter in daily life. Their concerns may mount as they age, if only because they have fewer opportunities to recover from what may be a major financial loss. Proper risk management practices should start at a young age. These desirable practices are described in this chapter. We begin with a discussion of risk management in theory as well as in practical terms. The balance of the risk manage- ment portion of the chapter is presented as a flow process. It shows you step-by-step how to establish and implement a risk management program. Information on overall types of insurance and their use is then provided. Finally, life insurance is discussed in some detail. After reading this portion of the chapter, you should be able to determine life insurance suitability and evaluate the alternatives. In Chapter 12 you will read about other kinds of insurance. We can conclude by saying that risk management is a very broad topic affecting most of the things that you do. To refer to it simply as insurance does not do justice to the topic.

RISK MANAGEMENT Risk Management Theory Risk management in theory can be viewed as the study of methods for controlling port- folio risk. As discussed in the last two chapters, the portfolio for individuals consists of all their household assets. A variety of risk management tools are available to modify house- hold risk. The ones you select will depend on such factors as the makeup of all of your household assets and your risk profile. The goal is to have the highest quality of life pos- sible, given your tolerance for risk. There is no grouping of assets or other techniques that can fully eliminate risk in your portfolio. Perhaps the biggest difficulty in doing so is the lack of a full hedge for the life- time work-related income streams we call human assets. We cannot fully diversify human assets.1 There are usually only one or two wage earners who make up human assets possi- ble per household. Products with negative correlation with human