Financial Planning and Investments

Many of the financial decisions that individuals have to make in their personal lives - choosing a mortgage, investing in their savings, planning for retirement - require using financial models. In this blog I illustrate additional applications of the time value of money concept and also involve inflation and taxation.

Inflation

Inflation is one of the key factors that has to be incorporated in many models for making personal finance decisions, especially when long-term planning is involved. If you are saving money to buy a car three years from now, inflation may not be an important factor. But if you are 30 now, plan to retire at age 65, and expect to live until you are 90, inflation must be factored into the models you use. For example, it is impossible for any of us to guess how much we will need in nominal Rands per year during retirement - it may be 35 years away! However, we may be able to say more comfortably that we will need in today’s Rands (also called constant Rands or buying power) an amount equal to 80% of our current expenses.

Long-term planning has to be done in one of two ways. We can do the analysis in constant or real Rands, but then we cannot reflect taxes realistically because taxes have to be paid on nominal rand income and investment returns, not on real rand amounts. Alternately, we can do all calculations in nominal Rands but carefully reflect in them the impact of anticipated inflation.

Taxes

We generally have to factor in three types of taxes into our models: income taxes, taxes on dividends (if any), and taxes on capital gains.

Income taxes apply to wages, salaries, and other income, as well as most interest income (except where there may be exemptions, for example on savings or certain bonds). This tax is charged at different rates depending on one’s income level or tax bracket. Unless you want to calculate income taxes in detail by taking into consideration different rates for different tax brackets, you should generally use the marginal tax rate in your models.

Capital gains are defined as the appreciation in the value of an investment asset. One important point to keep in mind is that capital gains taxes have to be paid only when the asset is sold (unless there are applicable exemptions, for example on your primary home); until then no taxes have to be paid, even if the asset’s value keeps growing. When we buy and sell assets over time in tranches, the calculation of the capital gains taxes can get somewhat complicated.

In building models, you have to know whether you are dealing with taxable accounts, tax-deferred accounts, or tax-free accounts. Sometimes you can develop models that will work for both taxable and tax-deferred or even tax-free accounts. For taxable applications, the user has to input the appropriate tax rate, and for tax-deferred and tax-free applications the user will set the tax rates to zero. However, not all models can be built with this flexibility, and you should always document any tax-related limitation a model.

Reinvestment Income

Many stocks pay dividends, and most fixed income investments (for example, bonds) provide ongoing interest income. Unless these investments are in tax-deferred accounts, we have to pay taxes on these returns before reinvesting the funds at rates available at that time. Because the taxes and the reinvestment rates we assume can significantly affect actual returns earned over time, our models should explicitly incorporate them and let the user specify the tax rates as well as reinvestment rates.

Structuring Portfolios

For long-term investment success, it is essential that an investor creates and maintains a properly structured portfolio. A portfolio is generally structured at three levels.

First, the investor has to choose the broad asset classes (for example, stocks, bonds, etc.) in which to invest and decide how much of the portfolio to invest in each asset class. That is generally called the portfolio’s asset allocation. Studies have shown that a portfolio’s asset allocation has the largest impact on its long-term return.

Second, the investor has to choose within each asset class the categories of securities in which to invest. For stocks, the categories may be large-cap stocks, small-cap value stocks, and so on. For bonds, these may be short-term bonds, long-term bonds, foreign bonds, and so on. The investor must then decide what percentage of his allocation to each asset class he wants to allocate to each category within that class.

Third, within each category of securities the investor has to choose specific securities and mutual funds and decide how much to invest in each of them. To make this decision, the investor will probably start with a select list of stocks of funds in each category and then do an allocation among them.

Although both financial theory and analysis of historical data provide some guideline for portfolio structuring, there is quite a bit of leeway in choosing the allocation at each level. There is no perfect answer, and even for the same person the “right” portfolio will change over the years as family circumstances change (for example, children finish college, the person approaches retirement, and so forth). Although most people think they should adjust their portfolios at least periodically in response to changing market outlook, market history shows that no one can reliably predict what the market will do in the future and which stocks will do better than others over the years. Contrary to what most people believe, then, the structure and holdings of a portfolio should not be influenced much by anyone’s views on the market outlook.