Category: Financial Planning

A perspective on Integrated Financial Planning

As avid investors, we come across many general rules on financial planning in different financial media. Some of the rules help investors make reasonable financial decisions. The explanations behind such rules often provide the intuition behind how investors make sound financial decisions—a reason why we will discuss these rules here. Nevertheless, general rules are insufficient to meet investors’ financial needs. One issue with general rules is that one-size-fit-all rules do not consider the differences in investors’ situations. Another issue is that they tend to make investment recommendations in isolation instead of fully incorporating different aspects of an investor’s situations.

When we make financial decisions, we consciously or unconsciously incorporate a wide variety of factors into our decisions. Such factors encompass different aspects of our financial and non-financial situations. Instead of accepting general rules published in financial media, we recommend that investors evaluate their own situations before making decisions that fit their needs. For example, a popular rule suggests that investors reduce exposure to stocks after retirement. For a retiree who relies on limited financial assets to support future spending, it makes sense to reduce risk by reducing exposure to stocks. For the retiree—among the lucky ones—who has a guaranteed pension, the incentive to reduce risk is less clear. He may or may not need to reduce exposure to stocks. For a retiree who is financially secure and wants to pass his wealth on to his children, he has no needs to reduce exposure to stocks. The bequest motive essentially extends the investor’s investment horizon to his children’s. The following are a variety of factors that investors consider in make financial planning decisions:

·        Age

·        Current income and income trajectory

·        Retired?

·        Family

·        Financial assets and liabilities

·        Human capital

·        401k, pension, and Social Security

·        Real estate ownership and mortgage debts

·        Saving and spending behavior

·        Investment horizon

·        Risk preference (e.g. capital preservation versus capital appreciation)

·        Bequest motive

We recommend that investors use an integrated approach to make financial decisions similar to the one shown here. When investors evaluate their financial situation, they should recognize that the financial capital—financial assets that investors own minus any liabilities—is only part of their assets. For investors who are currently working or may work in the future, human capital—the value of an investor’s future earnings from employment—is an asset that may be more valuable than financial assets. For the majority of American families, their houses are the biggest tangible assets (may also be the biggest liabilities). Therefore, when evaluating financial situation, investors should consider human capital and real estate along with financial capital. Some investors may also have part of their wealth in other non-financial assets such as stakes in family business, art collections, stamp collections, antiques, and royalties from published books. Investors should include them in making financial planning decisions.

For financial planning, investors start with their financial situations and incorporate risk appetite as well as their forecasts of the returns and risk of different investments. An investor’s financial situation often influences risk appetite. Typically investors who can afford to lose part of their wealth have higher risk appetite, which is a reason why wealthy investors allocate higher percentage of their money to risky assets. In other words, wealthy investors have the financial ability to take more risk. Non-financial situations also influence investors risk appetite. For example, investors in stable countries are willing to take more financial risk while investors in less table countries have higher preference for safe-haven assets. Individual personality has a large impact on risk appetite as well. Some investors have the natural tendency to take high risk while others are far more risk averse. Naturally, investors with high risk tolerance tend to invest more in risky assets than similar investors who are risk averse. The expected return and risk of different investments have large impact on financial planning as well. During stock market booms such as late 1990s, investors had high expectation on stock returns and shifted more investments into the stock market. Similarly, during housing booms such as early 2000s, some investors believed that the housing prices would always go up and took on home equity loans to finance their spending. In behavioral finance, such phenomenon is called recency bias. Essentially, investors are inclined to remember the recent years’ return of an asset class and extrapolate that return to the future. To make rational investment decisions, investors should avoid recency bias and make more objective forecasts on expected return of their investments.

When investors make financial decisions, it is not just a decision on investments. Instead, they need to make decisions on investments, savings & spending, and life insurance jointly. Life insurance (as well as disability insurance) protects investors and their families against possible human capital loss caused by death or disability. In other words, it is a hedge against possible losses of one of the most important assets that investors hold. Before investors decide what to invest, they need to decide how much to invest through savings. To make savings decisions, investors evaluate the trade-off between spending now (instant gratification) or spending later (delayed gratification) and the expected financial needs in the future. The size of the savings naturally impacts the size of the investments as investments reflect cumulative savings and investment returns. The size of the savings also influences a person’s risk appetite. Investors with more savings may be more financially secure to take more financial risk.

Our portal takes all this and more into account. We are all about Strategic Asset Allocation. Unlike others we are Active. Because the opposite of Active is broken, dead, inactive, inoperative, kaput, nonfunctional, nonoperative.

Strategic Asset Allocation is responsible for the majority of long term variation in portfolio returns. Yet, it is glossed over and subsumed to making tactical calls, products and fund manager selection. Extending the not so modern portfolio theory and variants of mean variance optimization to create ‘model portfolios’ is undifferentiated and suboptimal; moreover, it just does not work in the real world. In a matter of minutes we allow you to analyze the forward looking statistical properties & expected behavior of what you already own. We then help you find the best combination of asset classes that maximizes your long term risk return tradeoffs. Unlike choosing from a menu of model portfolios we help you arrive at bespoke allocations. A personalized allocation that accommodates your preferences for alternative investments, tolerance for illiquidity, your investment horizon, your risk tolerance levels, your investing horizon as well as your other needs.

This is what we mean by integrated financial planning. We also believe that convergence of our digital technology in the hands of an expert financial advisor will deliver better investment outcomes.