Iowa Electronic MarketsPersonal Finance and Portfolio Management Strategies Personal Finance Curriculum using the Federal Reserve Monetary Policy Market and Computer Industry Returns Market
Personal Finance and Portfolio Management Strategies byJan E. ChristopherDelaware State UniversityandJuliet U. EluSpelman College August 2001
Learning Objectives • Objectives -- Students should be able to: • Understand how the IEM can be used to make rational investment decisions • Explain the relationship between the IEM, financial responsibility, and mortgage and asset acquisition • Explain how the IEM predicts the movement of financial markets such as the stock, bonds and alternative investment markets • Use the IEM as a framework to track existing portfolios and predict movements in the equity markets
Lecture OutlinePersonal Finance and Portfolio Management Strategies 1. Introduction: Personal Finance Planning Budgeting and Cash – flow Management Money Management Strategy Credit and Debt Management Tax Planning 2. Providers of Financial Services and availability of Funds Banking Services and Savings Plan Mortgage and Tangible Assets Financing Interest Rate Fundamentals Stocks, Bonds and Mutual Fund Quotations Insurance Services and Hedging Strategies 3. Investment Decisions Understanding the Relationship between Personal Finance and Investment Using the IEM to make Rational Investment Decisions Trading and Tracking Stocks using the IEM Predicting Future Trades Based on Historical Trends Understanding Risk and Return 4. Summary
Introduction The Personal Finance and Portfolio Management Strategies module seeks to define the correlation of money management strategies with economic and political activities using the IEM. Students will be introduced to classroom materials that enable them to understand the impact of consumer credit and debt as they apply to personal financial management strategies. The IEM will be used to predict and forecast market outcomes. Upon completing a series of assignments, students will be able to understand the importance of personal financial planning and economic activities. In addition, Internet activities will be assigned to explain why banking services, developing personal savings plans, and interpreting payment accounts are paramount to personal financial management strategies.
Why Financial Planning Is Beneficial • Personal financial planning is the process of managing your money to achieve personal economic satisfaction. • There are several advantages of personal financial planning: • Increased effectiveness in obtaining, using, and protecting financial resources. • Increased control over one’s financial affairs. • Improved personal relationships. • A sense of freedom from financial worries.
The Financial Planning Process • Assess your current financial situation • Set financial goals • Identify alternative courses of action • Evaluate alternatives • Create and implement a financial action plan • Reevaluate and revise your plan regularly
What Variables Affect the Financial Planning Process? • Opportunity cost of money – the trade-off between present and future consumption • Risk assessment variables – such as inflation risk, interest rate risk, loss of income, personal risks, and liquidity premium • Realistic financial time frames – near-tern, short run, long run – for investments based on financial needs • Personal values – size of households, marital status, divorces, general norms and ethics • Economic forces – Federal Reserve policy, global influences, and market forces • Changing economic conditions– Consumer prices, spending habits, interest rates, Gross Domestic Product (GDP), balance of trade, and fluctuations in stock market indexes
Significant Terminology Used in the Financial Planning Process The “time value of money” is the increase in an amount of money that results from interest earned on an investment. The time value of money is usually categorized into two components: the present value and the future value. The “future value of money” is a compounding process over time, i.e., the amount to which a sum invested can increase over time based on the number of years invested. The “present value of money” is the reverse of the future value and involves a discounting process that reflects what the investment is worth in current dollars.
Example of the Compounding Process Using Future Value FV = PV(1 + i)n where n = number of years The future value of $100 at an 8% interest rate to be received in 1 year is: FV = 100(1+.08)1 = $108 Note: to take advantage of the compounding process, present consumption must be sacrificed.
Example of the Discounting Process Using Present Value PV = FV (1 + i)n where n = number of years The present value of $100 to be received at the end of one year at an 8% interest rate is: PV = 100 (1+.08)1 = $92.59
Example of the Future Value Interest Factor for an Annuity The future value interest factor for a one-dollar annuity discounted at i percent for n periods of $1000 to be received at the end of three year at an 6% interest rate is: FVIFA 6%,3 = (1+.06)2 + (1+.06)1 + (1+.06)0 1.1236 + 1.06 + 1 = 3.1836 FV of the Annuity = PMT(FVIFAi,n)= $1,000 x 3.184 = $3,184
Example of the Present Value Interest Factor for an Annuity The present value interest factor for a one-dollar annuity discounted at i percent for n periods of $1000 to be received at the end of three year at an 6% interest rate is: PVIFA 6%,3 = ___1___ + __1__ + ___1___ (1+.06)1 (1+.06)2 (1+.06)3 .9433 + .88999 + .83961 = 2.673 PV of the Annuity = PMT(PVIFAi,n) = $1,000 x 2.673 = $2,673
Budgeting • Budgeting is the process of projecting, organizing, monitoring, and controlling future income and expenditures. Items such as cash, credit purchases, savings, transportation, homeownership and living arrangements are within the parameters of the budgeting process. A budget should project actual income and expenditures, which are presented on an income statement. Financial planning consists of creating a balance sheet showing assets, liabilities, and net worth. Effective financial management requires reconciliation of the income statement and balance sheet. • Financial planning and budgeting are positively correlated, and are paramount to personal financial planning process.
Cash-Flow Management • Cash Management is the task of maximizing interest earnings and minimizing fees and other costs of living. Cash management involves those funds that are kept readily available and relatively liquid for household expenses, investment opportunities, and emergencies. • The primary providers of cash management services are banks, non-bank financial institutions, mutual funds, stock brokerages, licensed lenders, and other financial services institutions. • Tools of cash management include interest-bearing checking accounts, savings accounts that compound interest daily, certificates of deposits, U.S. government bonds, government securities, and money market accounts such as super NOW accounts, money market mutual funds, and asset management accounts.
Money Management Strategies • Effective money management strategies include organizing and maintaining personal financial records, overseeing the household budget, handling the checkbook, and achieving financial goals based on careful planning through the balance sheet and cash flow statements. • A cash-flow statement summarizes all cash receipts and payments for a given time frame. The cash flow statement provides information on income and spending behavior. • A balance sheet, also known as the net worth statement, lists all items of value and all amounts owed. These are referred to as assets and liabilities, respectively. The balance sheet illustrates projected savings and expenses. • A budget assesses the current financial situation, provides direction for achieving financial goals, creates budget allowances, and provides feedback for evaluating planned objectives.
Key Variables in Asset Management Strategies • Asset Management, also known as Money Management, is the individuals’ ability to select from different investment alternatives (tangible assets) that will allow the achievement of financial goals. The main goal of Asset Management is to maximize the wealth of the individual, including the ability to minimize risk, hedge against inflation, obtain financial stability and provide for one’s family. Tangible Assets include: • Personal and Employment Records • Tax Records • Credit Records • Consumer Purchase Records • Housing or Rent Records • Investment Records • Items of Value • Automobile Records
Key Indicators of Good Financial Management • Debt Ratio – Liabilities/Net Worth • Current Ratio – Liquid Assets/Current Liabilities • Liquidity Ratio – Liquid Assets/Monthly Expenses • Debt Payment Ratio – Monthly Credit Payments/Take Home Pay • Savings Ratio – Amount Saved Per Year/Gross Annual Income
The Debt-to-Equity Ratio • Equity, also known as Net Worth, is the value of the items that individuals own. In general, Net Worth is the equity that remains when the individual owners calculate the sum of their assets minus the sum of their liabilities. • Liabilities are the claims to Equity from owing to creditors more than the sum of one’s current income and existing Net Worth. For example, liabilities can include car payments, credit card balances, charge card balances, insurance premiums, student loans, bank loans, small personal loans, alimony, child support, retroactive taxes, and loans promised to repay family members and friends. From a societal point of view, an individual’s liabilities do not include the value of the home and the amount of the house payments. • The Debt-to-Equity Ratio calculates the amount of consumer debt as a ratio of the assets an individual owns. For example, a person with $24,000 in debts and $60,000 in assets has equity of $36,000 ($60,000-$24,000); or a Debt-to-Equity Ratio of 0.67 ($24,000/$36,000), which is considered high by financial solvency standards. If the Debt-to-Equity Ratio is close to 1 then the individual has reached an upper limit in debt obligations. As a rule of thumb, the Debt-to-Equity Ratio should not be more than 0.33.
The Current Ratio • The Current Ratio is the proportion of Current Assets to Current Liabilities. In personal finance, monthly utilities can be regarded as part of current liabilities. Individuals should know their current liabilities on a regular basis to understand the impact of their utility bills (e.g., gas, electric, water and sewage, telephone and wireless communications, trash collection, Internet and cable) on disposable income, in order to maintain payments on one’s remaining liabilities. • For example, with rising natural gas and heating oil prices, an individual’s consumption could have increased from $650 per month in December 2000 to $1,150 for the month of January 2001. If current liabilities were $2000 per month in December and $2,500 in January, then the current ratio will be 20% ($2,000/$5,000x100) in December; and 50% ($2,500/$5,000x100) in January.
Liquidity Ratios • The Liquidity Ratio is the ability of individuals to turn their assets into cash with minimum or no transactions costs. The basic liquidity ratio calculates the number of months a household can continue to meet its expenses from monetary assets after a total loss of income. • Examples of liquid assets include, Certificates of Deposit, interest and dividends earned from assets, mutual funds, and the selling of assets, including the selling of stocks and bonds. • For example, if total expenses for the month of January 2001 were $2,500 and monetary liquid assets necessary to pay the January expenses were $4,000, then the basic Liquidity Ratio would be 1.6 ($4,000/$2,500). This ratio shows that the individual only has monetary assets to support about one and one-half month’s expenses. Research demonstrates that individuals should have at least three months in monetary cash reserves for emergency purposes. Consumption patterns may vary; however, the higher the liquidity ratio, the better.
Debt Service-to-Income Ratio • The amount of total monthly debt payments an individual makes is considered to be the individual’s debt service. The debt service is calculated on gross income when mortgage payments are taken into consideration, yet are calculated on net income when house payments are excluded (since mortgages are classified as long-term liabilities). • When the debt service amount is compared to the individual’s disposable income, a benchmark of 20% or less is used. Individuals who spend more than 20% of their monthly income on debt obligations have no flexibility in their monthly budget expenses. • For example, in January 2001 an individual’s monthly debt payments were $2,500 and income was $5,000; the debt service-to-income ratio is 50% ($2,500/$5,000).
The Savings Ratio • From an economic perspective, saving is the difference between disposable income and consumption. In other words, income not spent on current consumption is saved. • The savings ratio is the proportion of the total annual amount of savings to total annual disposable income. A high savings ratio indicates lower debt service. A high income does not necessarily indicate a high savings ratio, however. High income individuals may spend additional income on tangible assets or investments; and low income individuals may spend a disproportionate amount on debt service. At low incomes most individuals have a zero savings ratio. • Hence, the savings ratio may depend on individual consumption patterns. On a monthly basis, the savings ratio is the amount saved each month divided by total monthly gross income. Individuals should save at least 10% of their income. For example, if total gross income is $5,000 per month, then the expected savings should be $500 for that month.
Develop a Debt Management Plan to Control Credit Usage Develop a plan to manage debt. The major sources of consumer credit are financial institutions such as commercial banks, building and loan associations, licensed lenders, credit unions, credit card banks, risk managers, and insurers. Other sources of credit are non-financial, including governmental agencies, families, friends, and community-based organizations. Debt management is the ability to meet debt obligations in both the short term and the long term.
Credit Management • The cost of credit includes the finance charge quoted as the Annual Percentage Rate (APR). • Interest payments represent part of the finance charge. Other components of the finance charge can include service charges, appraisal fees, credit-related insurance premiums, and punitive interest rates levied on certain borrowers. • The Annual Percentage Rate (APR) reflects the actual rate of borrowing. It expresses the relative cost of credit on a yearly basis and is the key to comparing costs between and among lenders. • Approximate APR = 2 x n x I P(N + 1) • where, n=Number of payment periods in one year • P=Principal, net amount of the loan • I=Total dollar cost of credit • N=Total number of payments to pay off loan
Debt Management • Debt can be a serious problem if not controlled properly. Evidence of debt mismanagement can include, but is not limited to: • Emotional problems • Loss of income • “Keeping up with Jones;” “Keeping Ahead of the Smith” • Overindulgence • Instant gratification • Using money to punish or to comfort • Sickness and Long-term Illness • Unemployment • Overextending • Miscommunication and misunderstanding of finance charges
Signals of Debt Mismanagement • According to the Consumer Credit Education Foundation, some of the warning signals of a potential debt problem: • Paying only the minimum balance on a credit card bill each month • Missing payments • Paying late • Paying some bills this month and others next month • Intentionally using the overdraft or automatic loan feature on a checking account • Putting off medical and dental visits because you cannot afford them right away • Unable to handle unexpected expenses • Depending on overtime or moonlighting to meet everyday expenses • Taking frequent cash advances on credit cards
Tax Planning Tax Planning Strategy is the ability of an individual to effectively reduce, defer, or eliminate some taxes. Tax planning can influence an individual’s spending, savings, borrowing, and investment decisions. An understanding of the tax laws and maintenance of appropriate records can assist an individual to take advantage of some tax shelters. To successfully achieve this goal, it is essential to determine one’s current tax liability and the impact of the liability on financial transactions. Personal income tax is assessed on taxable income and the objective is to legally pay your fair share of taxes while taking advantage of the tax benefits appropriate to your personal financial situation.
Tax Planning (continued) • Administration and Classification of Taxes - Taxes are compulsory charges imposed by the Federal, State, and Local governments on citizens. Taxes are major sources of revenue for the government and as such are mandatory and affect one’s personal finance decision. • There are four distinct types of taxes: • Taxes on Purchase - These are taxes imposed by state and local governments that are added to the purchase price of the product such as a sales tax. With the exceptions of (Alaska, Delaware, Montana, New Hampshire, and Oregon) all states have a sales tax. Another form of purchase tax is the excise tax that is a tax levied on specific goods and services, such as gasoline, cigarettes, alcoholic beverages, air travel, and tires. • Taxes on Property - These are taxes imposed by local governments on real estate and serve as a major source of revenue for the municipality.
Tax Planning (continued) • Taxes on Wealth - This can be an estate or inheritance tax. The estate tax is imposed on the value of a person’s property at the time of his or her death, while the inheritance tax is levied on the property bequeathed by a deceased person. • Taxes on Earnings - These are taxes imposed by the Federal government on income earned from wages, interest earnings from bonds, dividend earnings from stocks, all capital gains from tangible and non-tangible assets, and any other income received from miscellaneous employment. The income tax levied by the Federal government is the largest tax component paid by individuals, and it serves as a major source of revenue for the Federal government and, as such, is based on the ability-to-pay concept. The federal income tax is progressive in nature which means that the higher an individual’s or household’s income, the higher the percentage of tax that individual or household must pay. See tax rates table below:
Marginal and Average Tax Rates • The concepts of marginal and average tax rates explain why some individuals choose to maximize income, whereas others choose to remain in lower tax brackets to minimize their overall tax liabilities. • The marginal tax rate is the tax paid on additional income earned and it is used to ensure the progressive nature of the income tax. The average tax rate is the total tax liability as a percentage of income. As a rule, the marginal tax rate will be greater than the average tax rate. If the average tax rate is greater than the marginal tax rate, then it is a regressive tax which implies that the higher one’s income, the lower one’s tax liability. • Example: A single individual with a taxable income of $45,000 will pay a tax of $5,390 [(45,000 - 25,750(.28)] (Refer to tax the table above.)The average tax rate is 12% [(5,390/45,000 x 100)]. • The marginal tax is 28% and the average tax is 12%.
The Ways Taxes Are Paid • Taxes are paid through payroll withholding and estimated taxes. The most common is the payroll withholding method which is where the employee authorizes the employer to withhold a portion of the employee’s income for tax purposes. The amount withheld is based on the amount of income earned, the number of exemptions, the number of dependents reported by the employee on Form W-4 (the Employee’s Withholding Allowance Certificate), and the possible estimated tax liability. The estimated tax method is for self-employed individuals where tax liability is estimated and paid in quarterly installments. Form 1040-ES (Estimated Tax for Individuals) must be filed.
Calculating Adjusted Income • The federal income tax is based on the earned taxable income, adjusted for allowable deductions, from which net taxable income is computed. Gross income includes, but is not limited to, wages, profits, interest payments, dividends, alimonies, child support, gaming and lottery incomes, commissions, property rentals, and all other monetary awards. Deductions include standard deductions and exemption, or itemized deductions and exemptions. The gross income less deductions is equal to the net taxable income (see tax table above for tax brackets). • Example: Brenda Charles had earnings from her salary of $40,000, interest on savings of $800, a contribution to an Individual Retirement Account (IRA) of $1,500, and dividend earnings of $600. What is Brenda’s adjusted income? Salary Earnings $40,000Interest on Savings 800 Dividend Earnings 600 Total Gross Income $41,400 Less IRA 1,500 Adjusted Income $39,900
Tax Shelter Strategies • The objective of tax strategy is to legitimately reduce one’s tax burden and concurrently not to evade paying tax. Some of the strategies related to tax planning include, but are not limited to: • Consumer purchasing strategy - In personal finance, one of the biggest tax shelters for consumers is the purchase or ownership of real estate (residential and otherwise). The cost of financing which is the same as the interest payment for real estate property and mortgages is tax deductible (as itemized deductions). People with equity in their homes can consolidate their finances by obtaining home equity loans (second mortgages) to purchase other tangible items, such as cars, furniture, and even payoff credit card bills, while taking advantage of the low interest rates on second mortgages and the ability to deduct taxes paid at the end of the year. Individuals are allowed to deduct interest on loans of up to $100,000 secured by their primary or secondary home up to actual dollar amounts invested in the home.
Tax Shelter Strategies (continued) • Job-Related Expenses as itemized deductions. The current tax law allows individuals to deduct business-related expenses such as travel expenses, membership dues, education costs, job search expenses, and miscellaneous expenses associated with professional development activities. • Investment Decisions • Tax-exempt Investment Instruments. Most municipal bonds that are issued by state and local governments are tax exempt. Even though they have lower interest rates, for people in the 28 percent tax bracket and above, the after-taxincome may be higher when compared to investing in a taxable instrument. For example, a $200 investment owned by an individual in the 28 percent tax bracket would be worth more than a taxable investment of $250. The $250 would have an after-tax value of $180: $250 less $70 (28 percent of $250) for taxes.
Tax Shelter Strategies (continued) • Investment Decisions (continued) • Tax-Deferred Investment Instruments. These are investments whose incomes can be taxed at a later date such as treasury bonds and retirement plans. For example, capital gains (profits from the sale of stocks, bonds, and real estate) can be deferred. Taxes are not due until the asset is sold and taxes are based on the income bracket and how long the assets are held. Effective January 2001, individuals in the 15 percent tax bracket with capital gains on assets held for a year or less are taxed at the ordinary income tax rate of 15 percent, gains on assets held for more than 1 year but less than 5 years are taxed at 10 percent, and gains on asset held for more than 5 years are taxed at 8 percent. For individuals in the 28 percent to 39.6 percent tax bracket with capital gains on assets held for a year or less, capital gains are taxed at the ordinary income tax rate, gains on assets held for more than 1 year but less
Tax Shelter Strategies (continued) • Investment Decisions (continued) • than 5 years are taxed at 20 percent, and gains on asset held for more than 5 years are taxed at 18 percent. Capital gains of $500,000 (couple filing jointly) and $250,000 (for singles) on the sale of a home may be excluded if used as a primary resident; however, this is allowed only once every two years. • Self-Employment. Business owners such as sole proprietors and partnerships have tax advantages because they can deduct expenses such as health and life insurance as business expenses. But they also have to pay self-employment tax, in addition to their regular income tax.
Tax Shelter Strategies (continued) • Investment Decisions (continued) • Children’s Investment. Investment incomes passed over to children (provided they are under 14) are tax exempt. Investment income over $1,300 is taxed at the parent’s rate, however, $650 is deductible, and the next $650 is taxed at the child’s rate of 15 percent. • Retirement Plans. The use of tax-deferred plans such as IRAs, Roth IRAs, Keogh plans, and 401(k) plans are highly encouraged for those people who do not participate in employer-sponsored retirement plans. People with adjusted gross income of $41,000 for singles and $61,000 for couples can establish the traditional IRA account of $2,000 per year which is tax deductible. Only in cases of emergencies such as death or disability, medical expenses, and qualified higher education expenses, will there be an exception to the rule, otherwise early withdrawals (before age 60) are subject to a 10 percent penalty.
Tax Shelter Strategies (continued) • The Roth IRA also has limited adjusted gross income guidelines. Roth IRAs are not tax deductible, but the earnings are tax deductible after five years and individuals can withdraw from it before retirement. The advantage of the Roth IRA is that the investment grows in value on a tax-free basis, and withdrawals are exempt from federal and state taxation. • The Keogh Plan is for self-employed individuals who are allowed to contribute up to 25 percent (maximum of $30,000) of their annual income on a retirement plan. The 401(k) plan authorizes a tax-deferred retirement plan sponsored by the employer. The employer contributes about 50 cents for each dollar to the employee’s retirement plan, and the employee is allowed to match it, if desired. • The retirement plan is a good way to minimize tax liability for people in low and middle income brackets. For people in the high income bracket, tax-deferred investments are the appropriate strategy for tax shelter.
Banking Services and Savings Plans • Banks provide four basic types of services • Savings accounts • Payment accounts and transfer of funds • Loans and credit alternatives • Other services, such as funds available for real estate, insurance, portfolio or investment management, tax assistance, financial planning, trust fund management, and asset management services. • The categorization of banks consists primarily of full service banks, wholesale banks, credit card banks, federal savings banks, state savings banks, trust companies, and non-deposit trust companies. • Cyberbanking provides computerized financial services using multimedia such as the telephone, the personal computer, and the Internet. Electronic banking includes such services as direct deposit, electronic funds and wire transfers, transfers of funds between accounts, electronic payments, point-of-sale transactions, stored-value cards, Automated Teller Machines (ATM), electronic cash (cybercash), and applying for loans online.
Savings Plans • Savings plans are financial services offered by commercial banks, building and loan associations, federal savings banks, credit unions, mortgage companies, life insurance companies, and mutual savings banks. • Types of savings plans include, regular savings accounts, certificates of deposit, money market savings accounts, money market mutual funds, annuities, U.S. government securities, flexible and whole life insurance policies, and Negotiated Order of Withdrawal (NOW) accounts.
Mortgage Financing • Mortgage financing has evolved to include mortgage-backed securities, Real Estate Investment Trusts (REITs), security debt and other financial instruments used to make home mortgages more affordable. • Other innovations in the mortgage markets include standardized mortgage documents, automated underwriting, automated tools to determine credit risks, and the creation of a market for conventional mortgage securities.
Real Estate Investment and Cash Flow • Real Estate Investments are a form of savings and are expected to generate positive cash flow when the amount received is greater than the expenses paid. • If rental property is owned, the amount of rental income remaining after paying all operating expenses including repairs and mortgage expenses is also called Cash Flow. • Positive cash flow is determined by current income. It is analogous to cash dividends received by owners of common stock and mutual funds.
Direct and Indirect Real Estate Investment • Direct Real Estate Investment • The investor holds the title to the property. • Home ownership is the major form of direct investment. Homeownership is a major asset of most households. • There are tax advantages and possible hedging against inflation with direct real estate investment. • Other forms of direct real estate investment can include land ownership, ownership of commercial rental property, and ownership of vacation homes and time shares. • Indirect Real Estate Investment • Real estate syndicates are usually organized as a corporation, trust, or limited partnership. • Real Estate Investment Trusts (REITs), which are similar to mutual funds, are a real-estate based investment tool. • First and second mortgages may be packaged as investments. • Participation certificates are equity investments in a pool of mortgages that have been purchased by a government agency.