Strategic Financial Planning over the Lifecycle: A Conceptual Approach to Personal Risk Management

Description

This book on personal financial planning and wealth management employs the lifecycle model of financial economics. The central idea of 'consumption smoothing' is used to connect chapters and topics such as saving and investment, debt management, risk management and retirement planning. The first part of the book is nontechnical and aimed at a wide audience with no special technical background. The second part of the book provides a rigorous presentation of the lifecycle model from first principles using the calculus of variations. The accompanying website is found at http://www.yorku.ca/milevsky/?page_id=185. Cover STRATEGIC FINANCIAL PLANNING OVER THE LIFECYCLE Title Copyright Dedication Contents Acknowledgments 1 Introduction and Motivation 2 Mathematical Preliminaries – Working with Interest Rates Learning Objectives 2.1 Interest Rates 2.1.1 Effective Annual Rate (EAR) and Annual Percentage Rate (APR) 2.2 Time Value of Money – Definitions 2.3 Present Value and Future Value of a Single Cash Flow 2.4 Present Value of an Annuity with Constant Payments 2.4.1 Ordinary Annuity 2.4.2 Annuity Due 2.5 Future Value of an Annuity with Constant Payments 2.5.1 Ordinary Annuity 2.5.2 Annuity Due 2.6 Present Value of an Annuity 2.6.1 Constant-Growth Ordinary Annuity 2.6.2 Constant-Growth Annuity Due 2.7 Future Value of an Annuity 2.7.1 Constant-Growth Ordinary Annuity 2.7.2 Constant-Growth Annuity Due 2.8 A Preliminary Discussion of the Effects of Inflation 2.9 Appendix: Geometric Progressions and Annuity Relations 2.10 Questions and Assignments 3 Personal Balance Sheet and Human Capital Learning Objectives 3.1 Personal Balance Sheets 3.1.1 Financial Assets 3.1.2 Gross Human Capital 3.1.3 Explicit Liabilities 3.1.4 Implicit Liabilities 3.1.5 Economic Net Worth 3.2 Estimation of Gross Human Capital 3.2.1 What Is Proper Discount Rate for Gross Human Capital? 3.3 Estimation of Implicit Liabilities 3.4 An Example of Human Capital Decisions: Investing in Education 3.4.1 Some Caveats 3.5 Questions and Assignments 4 Consumption Smoothing and Optimal Savings Learning Objectives 4.1 Consumption Smoothing 4.2 Assumptions for Consumption Smoothing 4.3 Solving for Smoothness 4.3.1 Effects of Changes in Other Parameter Values 4.4 Consumption Smoothing vs. Other Approaches 4.4.1 The Fixed-Percentage Savings Rules 4.4.2 The 70'045 Income Replacement Rule 4.5 Practical Considerations 4.6 Questions and Assignments 5 Debts, Loans, and Mortgages [Canadian Content] Learning Objectives 5.1 Mortgage Financing 5.1.1 Mortgage Amortization 5.1.2 Mortgage Insurance 5.1.3 Mortgage Refinancing Case 1: Do Not Refinance the Loan Case 2: Refinance the Loan 5.1.4 Fixed-Rate vs. Floating-Rate Loans 5.2 Borrowing to Invest 5.3 Debt Consolidation 5.4 Is Debt Good or Bad? 5.5 Questions and Assignments 6 Personal Income Taxes [Canadian Content] Learning Objectives 6.1 The Logic of Income Tax Calculations 6.1.1 Federal Income Taxes 6.1.2 Provincial Income Taxes 6.1.3 Combining Federal and Provincial Income Taxes 6.2 Investment Income 6.2.1 Interest Income 6.2.2 Dividend Income 6.2.3 Capital Gains/Losses 6.3 Income Tax Planning 6.3.1 Income Splitting 6.3.2 Tax-Deferred Investment Vehicles 6.3.3 Tax-Free Savings Accounts (TFSAs) 6.3.4 RRSPs vs. TFSAs 6.4 Questions and Assignments 7 Risk, Utility, and Insurance Learning Objectives 7.1 The Concepts of Risk and Risk Preferences 7.1.1 Definition of Risk 7.1.2 Risk Preferences 7.2 The Concept of Insurance 7.3 The Demand for Insurance 7.3.1 When Should People Buy Insurance? 7.3.2 How Much Should You Pay for Insurance? 7.3.3 The Effect of Current Wealth on Insurance Decisions 7.3.4 The Effect of Risk-Aversion Parameter on Insurance Decisions 7.3.5 Generalizations 7.4 Insurance and Consumption Smoothing 7.5 Questions and Assignments 8 Mortality Risk and Life Insurance Learning Objectives 8.1 Who Needs Life Insurance? 8.2 How Much Coverage Do You Need? 8.2.1 Human-Capital Approach 8.2.2 The Expense (Needs) Approach 8.3 Types of Life Insurance 8.3.1 Term Life Insurance 8.3.2 Cash-Value Life Insurance 8.4 Questions and Assignments 9 Investment and Diversification Learning Objectives 9.1 Investment Decisions and Consumption 9.2 Major Asset Classes 9.2.1 Cash Equivalents 9.2.2 Fixed Income (Bonds) 9.2.3 Equities 9.2.4 Commodities 9.2.5 Real Estate 9.3 Historical Returns 9.3.1 Arithmetic Average vs. Geometric Average 9.3.2 Correlations of Returns 9.4 Asset Allocation and Diversification 9.5 Mutual Funds and Exchange-Traded Funds 9.5.1 Mutual Funds 9.5.2 Exchange-Traded Funds (ETFs) 9.6 Summary 9.7 Questions and Assignments 10 The Mathematics of Portfolio Diversification Learning Objectives 10.1 Impressive Investment Performance: Real or Fake 10.2 Portfolio Diversification 10.2.1 Preliminaries 10.2.2 From Bernoulli to Binomial 10.2.3 The Central Limit Theorem 10.3 Portfolio Construction 10.3.1 Efficient Frontier for Two Assets 10.3.2 Efficient Frontier for More Than Two Assets 10.4 Summary 10.5 Questions and Assignments 11 Housing Decisions Learning Objectives 11.1 Buying or Renting? 11.1.1 From a Purely Financial Perspective 11.1.2 Other Aspects of the Decision 11.1.3 Our Recommendation 11.2 Questions and Assignments 12 Pensions and Retirement [Canadian Content] Learning Objectives 12.1 Longevity Risk 12.2 Retirement Plans that Provide Lifelong Income 12.2.1 Canada Pension Plan (CPP) and Old-Age Security Pension (OAS) 12.2.2 Defined-Benefit Pension Plan 12.2.3 Life Annuity 12.3 Optimal Retirement Spending Rate in the Presence of Longevity Risk 12.3.1 Retirement Spending Rates 12.3.2 Numerical Example 12.3.3 Including Pension Annuities 12.4 Summary 12.5 Questions and Assignments 13 Advanced Material: Part I. Continuous Time and the Calculus of Variations Learning Objectives 13.1 Wages and Salary in Continuous Time 13.2 Human Capital Values in Continuous Time 13.3 A Different Route: Same Destination 13.4 Does Human Capital Grow or Shrink over Time? 13.5 Implicit Liabilities in Continuous Time 13.6 Consumption Smoothing: A Second Look 13.7 Calculus of Variations 13.8 Smooth Consumption: A Final Look 13.9 Life and Death in Continuous Time 13.10 The Problem of Retirement Income 13.10.1 The Euler-Lagrange Equation 13.10.2 Wealth Depletion 13.10.3 Classifying the Different Retirement Trajectories 13.10.4 Explicit Solution: Exponential Remaining Lifetime 13.10.5 Explicit Solution: Gompertz Mortality 13.11 Back to the Working Years 13.11.1 Patient Individual k ≤ k < g 13.11.2 Relatively Impatient Individual k ≤ g < k 13.11.3 Impatient Individual g < k ≤ k 13.12 Conclusion 13.13 Questions and Assignments 13.14 Appendix 14 Advanced Material: Part II. Stochastic Optimal Control and the HJB Equation Learning Objectives 14.1 Dynamic Asset Allocation and Optimal Consumption 14.2 Asset Price Model 14.3 A Self-Financed Portfolio 14.4 The Asset-Allocation Problem 14.5 The Asset-Allocation-Consumption Problem 14.6 The Asset-Allocation-Consumption Problem with Deterministic Wage Income 14.7 An Advanced Stochastic Lifecycle Model 14.7.1 Model Specifications 14.7.2 HJB Equation for the Lifecycle Model 14.7.3 Closed-Form Solution 14.8 Questions and Assignments 14.9 Technical Appendix 14.9.1 Elementary Stochastic Calculus in Finance 14.9.2 Stochastic Dynamic Optimization 14.9.3 Finite Difference Method for Solving the HJB Equation 15 Concluding Thoughts and Next Steps 15.1 Portfolio Selection with Human Capital 15.2 Asset Location vs. Asset Allocation 15.3 Home Mortgage Financing 15.4 Life and Health Insurance 15.5 Employee Compensation and Proper Incentives 15.6 Choice of Defined Benefit vs. Defined Contribution Pensions 15.7 Starting a Retirement Pension Annuity 15.8 Estate Planning and Tax Arbitrage 15.9 The Real Options in Your Life Bibliography Index