BASIC FINANCIAL PLANNING ―TOOLS‖ BASIC WEALTH ACCUMULATION PRINCIPLES 1. FINANCIAL PLAN 2. INVESTMENT ―MARGIN‖ 3. EMERGENCY FUND 4. TAX TREATMENT 5. THE EMERGENCY FUND 6. INVESTMENT ―MARGIN‖ 7. TIME VALUE OF MONEY (―MAGIC‖ OF COMPOUND INTEREST) 8. IMPORTANCE OF CONSISTENT GROWTH 9. DOLLAR COST AVERAGING 10. DIVERSIFICATION INVESTMENT ―MARGIN‖ GROSS INCOME - TAXES = NET INCOME - NECESSITIES = SPENDABLE INCOME - LUXURIES = INVESTIBLE FUNDS EMERGENCY FUND PURPOSE TYPE OF INVESTMENTS AMOUNT FINANCIAL PLANNING TOOLS OTHER INVESTMENT PREREQUISITES? LIFE INSURANCE? HOME OWNERSHIP? OTHER? IMPORTANCE OF CONSISTENT GROWTH MR. A AND MR. B EACH INVEST $10,000 ON JANUARY 1 OF EACH YEAR FOR 10 YEARS. MR. A EARNS 10% EACH YEAR. MR. B EARNS: YEAR RATE YEAR RATE 1 10% 6 8% 2 12% 7 12% 3 50% 8 10% 4 40% 9 -50% 5 8% 10 10% WHAT IS THE AVERAGE RATE OF RETURN EARNED BY EACH? WHAT IS THE AMOUNT OF MONEY ACCUMULATED BY EACH? A $175,313 B $111,247 DOLLAR COST AVERAGING ($10,000 PER YEAR) STOCK # OF SH. CUMULATIVE YEAR PRICE PURCHASED # OF SHARES 1 $100 100 100 2 $90 111.11 211.11 3 $60 166.67 377.78 4 $120 83.33 461.11 5 $180 55.56 516.67 6 $90 111.11 627.78 7 $48 208.33 836.11 8 $90 111.11 947.22 9 $36 277.78 1,225.00 10 $115 86.96 1,311.96 AVERAGE PRICE = $____________ AVERAGE COST = $____________ MONTE CARLO SIMULATION Here is what you should learn from playing Game 1. 1. Returns are Volatile Average Returns are meaningful over the long-term, but the actual Returns you get year-to-year will vary greatly, just as they do when you pick your own cards. Over short time periods, you may do much better or far worse than the average. 2. The Sequence of Returns Matters if You Are Making Additions If you are making Additions to your Portfolio, and get the Average Return you expect over some specific period of time, the future value of your Portfolio can still vary greatly depending on the actual Sequence of Returns you get each year. If your big gains come in early years and your losses come in the late years, you will accumulate less money than if the Returns occur in the reverse order. If you simply invest a lump-sum of money and let it grow without Additions, the Sequence of Returns does not affect the ending value, as long as you obtain the Average Return over the entire period. 3. Plan for a Range of Possible Outcomes You shouldn't plan for a specific future Portfolio Value, but instead expect your result to fall within a range of possible values, depending on the Sequence of Returns you get. There is no way to project any specific future value. The best you can do is plan for a reasonable range of possible outcomes. The analysis is based strictly on Historical Returns for the selected 30 year period, which may or may not have any relationship to future results. INVESTMENT RETURNS CURRENT YIELD BEFORE TAX: current annual income / current market price AFTER TAX: current annual income (1 – t) / current market price Can be used with bonds, stocks, and other investments. Says nothing about capital gains but can be useful for meeting income needs. HOLDING PERIOD RETURN BEFORE TAX: Total current income + total capital appreciation / total initial investment EXAMPLE: Stock purchased for $1,200; $50 in dividends received; sold for $1,500. ($50 + $300) / $1,200 = 29% AFTER TAX: Total current income (1-t) + total capital appreciation (1-t2) / total initial investment EXAMPLE: The tax rates might be different, say, 25% and 15% $50 (1 - .25) + $300 (1 - .15) / 1,200 = 24% APPROXIMATE YIELD BEFORE TAX APPROXIMATE YIELD ANNUAL FUTURE PRICE – CURRENT PRICE ______________________________ INCOME + NUMBER OF YEARS ______________________________________ FUTURE PRICE + CURRENT PRICE _____________________________ 2 TAXATION OF MUNICIPAL BONDS MUNI BOND YIELD 5% TAXABLE BOND YIELD 6% IF t = 15%, WHICH BOND SHOULD BE PURCHASED? Tax-exempt yield Equivalent fully = ____________________ taxable yield 1-t OR .05 ____________ = .85 = 5.88% THE INVESTOR WOULD BE BETTER OFF TO BUY THE TAXABLE BOND 6% - (.15)(6%) AND AFTER TAX YIELD WOULD BE 6% - .9% OR 5.1% DIVERSIFICATION DIVERSIFICATION CAN BE ACHIEVED BY: TYPE OF ASSET Cash equivalents, bonds, stocks, real estate, etc. MATURITY DATE GEOGRAPHY INDUSTRY SPECIAL TRAPS ARE: Company stock Industry-employment related A LOOK AT THE ―TOOLS‖ AS PRESENTED IN THE TEXT (The ―Golden Principles‖ of Financial Planning) 1. Cover your assets before taking greater risk. 2. Seek first a return of principal before a return on principal. 3. No risk, no reward. 4. Without both liquidity and marketability, there is no flexibility. 5. A successful investor has to be right three times. 6. An investor should never put all his eggs in one basket. 7. Put yourself on your own payroll—at the top of the payroll. 8. Capitalize on the miracle of the ―forgotten‖ automatic investment. 9. It is as important to increase the rate of investing as it is to increase the rate of return. 10. Let purpose define the level of risk taken. 11. Assets and income maintain their utility only to the extent they maintain or increase their purchasing power. 12. Increase expenditures (especially nondeductible ones) at a lower rate than you increase your income. 13. Think of security only in terms of the bottom line. (It’s not what you earn, its what you keep). 14. He is wise who can turn top tax dollars into assets or spendable income without undue risk. (Estate planning, deductions, and deferrals). 15. The essence of risk management is protecting the ground that’s already gained without losing more in the process. 16. It’s not enough just to make money, an investor has to create automatic mechanisms to make money with the money he’s made. 17. Always use the lowest risk solution that satisfies the need. 18. At a certain point, action must replace cogitation and articulation. 19. No tool or technique is without cost. 20. Patience and discipline are the parents of financial success. 21. Whether it’s better to “own” or “loan” depends on one’s own situation. (debt versus equity). 22. Debt, like spending, should be at the discretion of and fully controlled by the investor. 23. Tax leverage is a concept similar to financial leverage and can provide similar advantages. (e.g. deferral). 24. The after-tax return on the repayment of debt is essentially risk free. 25. When planning for retirement, the wise planner and client will assume a lower than hoped for rate of return on investments, a higher than anticipated level of inflation and cost of living, and put less reliance on social security or a pension will provide. 26. When doing estate planning, the wise planner will assume the highest reasonable liquidity demands and the lowest reasonable cash to meet those needs. 27. The best investment, bar none, is education. 28. Before making any suggestion to a client regarding any investment or any tool or technique, the planner should ask and answer these questions: a) What are the advantages and disadvantages of viable alternatives? b) Which of the viable alternatives provides the highest return at the least cost with the greatest certainty? c) What happens if the client takes no action?
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