Fina Fi nanci ncial Pl Planni nning ng vs vs. Fi Fina nanci - PDF document

The Lifecycle Model of Saving and Consumption Aa Aaron Stevens EC1 EC171 71, 8 8 September 2011 1 Fina Fi nanci ncial Pl Planni nning ng vs vs. Fi Fina nanci ncial Economi Economics cs Fi Finan anci cial al pl plan anning g star arts with h go goal als:  Ho How w much much will will that hat co cost st? ? When hen?  Wh What rate do you expect to earn on investments? …ar arrive at how much to save now Fi Finan anci cial al eco economics cs star arts with h res esour urces ces:  Wh What do you have?  Wh What are your obligations?  Ho How w sho should uld yo you u allo allocat cate e yo your ur reso resources? urces?  Mi Minimize risks to guarantee success

Li Life- e-Cycle e Ec Economi onomics The conceptual framework to answer life’s financial questions: Household Composition Life-Cycle Sustainable Standard of Theory of Living Resources Saving and Consumption Annual financial plan Obligations (simple arithmetic) What’s o on Your Wh Balance Balance She Sheet? t? List your assets on the left-hand side List your liabilities on the right-hand side (Don’t worry about exact amounts) What assets did you list? What liabilities did you list? Is your net worth positive or negative? Does this balance sheet fairly represent your economic condition?

Wh What is Value? What is the e value e of f my my old 1985 F150 Truck? (I paid $1 $100 fo for it in Dec ecemb ember er, 20 2004) Wh What is Value? Source: ht http:// //usedcars.kb kbb.c .com/cars/cars-for-sale-Ford.F150-Regular-Cab/year-1985.1989

Wh What is Value? Accounting practices describe different tools for valuing assets and liabilities: • Book value • Market value Economic value measures the income that will be generated by an asset over it’s remaining useful life. Fut Futur ure e Income ncome Ho How does future inc ncome show up on n your bal balanc ance e sheet? eet? Why? y? Human Hu n Capital is the asset which enabl enables es you you to to gener generate ate labor abor incom ncome. e. Ho How much is your HC HC worth today? In 10 In 10 year years? In s? In 30 30 years? In 50 years?

A A Mi Milliona onaire At At Age Age 22! 22! Joe Jo e Bl Blow, age age 22 Jo Joe e ea earns rns $42,000 pe per r year Jo Joe e will work rk un until age age 66 (no t (n taxes, i interest r rate = = 0 0%) Yo Your ur Eco Economic Ne Net Worth As Assets Li Liabi abilities es + Cash - Short term debts + Securities - Long term debts + Property = Tota = otal Conve onventi ntiona onal As Assets = = Tota otal Conve onventi ntiona onal Li Liabiliti ties Conven entional NW = Co Conv. Asset ets - Co Conv. Liabilities es + Huma man Capital Econ Econom omic N c Net et Wo Worth = CNW + HC

Fut Futur ure e Consumpt onsumption on Wh What about future consumption? Yo You’re e go gonna have e to consume me (ea eat, buy shel elter er, clothes es, en enter ertainmen ment) fo for the e res est of f your life. fe. Ho How w much h ca can y you consume, over your li life feti time? Li Lifetime me Budge udget Const onstraint nt Your lifetime consumption is bounded by the value of your lifetime resources: Lifetime Conv. Human = + Consumption Net Worth Capital (recall, conventional net worth = assets - liabilities)

Fut Futur ure e Consumpt onsumption on is s a De Declining Liability Joe Jo e Bl Blow, age age 22 Ther There’s ev every chance Jo Joe wo would live to age 100. Risk Ri sk: Ou Outliving Your Mo Money Jo Joe e Bl Blow, age age 22 Since Joe will stop working at Si age age 66, 66, but but he he needs eeds to eat eat un until age age 100...

Co Convert Hu Human Ca Capital to to Fi Financial Wealth Du During working years, accumul accum ulat ate e fi finan anci cial al capi capital al to offset et the decl declining g val alue ue of hu human an cap apital al. Wh What’s s the Secret to Ac Accum umulate ulate Fi Financ nancial al Wealth? alth? Du During working years, accumul accum ulat ate e fi finan anci cial al capi capital al to offset et the decl declining g val alue ue of hu human an cap apital al. Sav Savings = Income - Co Consumption (th (the s secret is t is th that th t there is is n no s secret! t!)

Two Tw o Per Period od Model odel You are young You are young Each period of and you work. Ea k. , in real time , , is time, roughly 30 roughly 30 You are old and years of years of Yo you die. you die. adulthood. adulthood. 17 Budget Co Bu Constraint: Yo Yout uth When you’re Wh re young, you work and receive recei e labo abor r inco come. e. + = What you earn What you earn (labor income) (labor income) Cy + Cy + S S = W What you consume What you consume What you save What you save in your youth in your youth

Bu Budget Co Constraint: Ol Old Age Age Wh When you’re re old, you live by consuming (s (spend nding ing d dow own) y n) you our s saving vings. C o = = S Amount saved Amount saved Consumption Consumption when young when young when old when old Li Lifet etime me Budget udget Co Constraint* It was for this work (in 1954) that Franco Modigliani won the Nobel Prize in Economics in 1985 Cy + S = W Co = S By algebraic magic: Co = W - Cy or Cy + Co = W *N *No Investment Return *N *No Taxes and/or Benefits

Wh What You Learned Today • Fi Financial Planning vs vs. . Fina nanc ncial Econo nomics • Ec Economic Value • Hu Human Capital • Th The Lifecycle Model explains the need to con conver vert hu t human an cap capital tal to fin to finan anci cial al cap capital tal (a (a pro rocess calle lled sa savings). • T The he 2 2 p peri riod m d mode del a and t d the he L Life fetime Bud Budget get Cons Constr trai aint nt Announceme Announc ment nts and nd To o Do Do Readings: • ME, E, ch2.1 .1, pp37-39 (today) Homew mework 1: Estima mate e your huma man capital (due e Tues esday)