Planning personal finance - Essay Example

Planning personal finance Describe the various stages of the typical lifecycle of an individual in the UK today and identify the most relevant financial products that should be considered at each stage Introduction It is obvious to everyone that there is a course of life with a start, middle, as well as an end. In looking at this stages there is an attempt to relate the stage an individual is in his/her life course with the type of issues that individual is facing as well as with the type of resources he/she will have access to in those issues (Carter & MCGoldrick, 2005, p. 46). And, ultimately, the type of disturbance the individual could develop if the issues do not go down as expected. The emphasis is that one level builds on the previous level or phase. With the psychology in mind, it is important to observe the investing as it relates with the course of life of an individual. Several investors are presently confused as to the best way to approach the construction of a precise portfolio of investments, so as to build wealth over their life course. The world has moved on from them traditional way of depending on cash for current liquidity needs equity investments for capital growth in the long run, bonds for income and may be gold as a hedge of inflation (Carter & MCGoldrick, 2005, p. 47). New categories of assets have come up, new investment methods are available and the construction of portfolio has become more sophisticated. Investors are, comprehensibly, always confused as to the best way to look after their long-term and medium-term financial interests as well as the way to build capital for the coming years. Lifecycle theory of investing The traditional lifecycle investing theory that was authored by Modigliani and Miller, holds that every individual will pass through several lifecycle stages, within which then needs for investment are different (Brigham & Houston, 200, pp. 73-4). The first stage is when younger, exists the ‘accumulation phase’ (between 20’s and 30’s age periods), when the person is capable of investing in greater risk assets as well as follow an aggressive strategy of investment, designed to attain maximum longer term growth. The second stage of lifecycle, is known as the ‘consolidation phase’, a middle life stage (between 40’s and 50’s age periods), during which the person has stopped working and is depending on the income as well as capital accumulated during the first two stages of life. The third and final stage is the ‘gifting phase’, (between 80’s and 90’s age periods) within which persons who have already accumulated a greater amount of wealth than they require for their own lifetimes, make a decision to of passing on some of their assets to others – maybe as a charitable donation or an inheritance (Brigham & Houston, 2001, pp. 74-5). According to this theory, individuals go through these phases of life, their investment objectives and needs change significantly and, even though they were capable of holding mostly risk carrying assets in their youthful years (the theory depends mostly on equities, for maximizing long-term growth), the person needs to eradicate most investment peril as they age up. The traditional approaches of asset allocation When it comes to asset allocation attitudes differ from country tom the other. The typical approach of ‘Anglo-Saxon’ is demonstrated by many investors in the UK (Loton, 2011, p. 12). Not very long ago, the simple rule of thumb was greatly applied. When younger, an individual should invest largely in equities for long term wealth building, because the individual can then benefit from the additional returns over time. As a result, UK pension funds always held 80% of the assets they possessed in equities. On the other, in the large Europe, there has traditionally existed a much higher tilting towards investing in bonds at the entire phases of lifecycle, so as to offer more security of capital and income safeguard, with the high weightings of UK equity being looked at as far ‘very risky’. The two approaches depend greatly on equities, including at younger ages, or too much of bonds (Green, 2011, p. 57). This makes the lifecycle of theory of investing very simple or meager for the contemporary UK. Breaking away from the traditional approach Following the significant development in financial markets and products over the last two decades, since the lifecycle theory initially sprouted, it has become important for investors to balance their portfolio of assets at all stages (Hawawini & Viallet, 1999, pp.102-105). Corporations are employing complex risk-management systems to achieve a balanced portfolio but this is yet to be useful for an individual. Teaching younger ages to invest majorly in equities exposes them to more risk than is warranted. Considering modern trends, a balance portfolio, consisting of hedge funds, inflation linked assets, property, venture capital, bonds and commodities, and straight equities, must be constructed, employing derivative products as an instrument for managing negative risk. In the older stages, depending squarely on bonds will still pose risk to investors, but also means sacrificing significant amount of potential gain. In this case also a more balance portfolio, consisting of venture capital, hedge funds, commodities and real estate, not forgetting bonds and inflation linked assets, would be expected to result into superior returns over time (Economywatch, 2010). Negative risk safeguard employing derivative products can still be useful. It is worth noting that the mix of investments is prone to change over the stages of lifecycle, with emphasis shifting more to less volatile assets as an individual moves to older stages, but this has to be gradual, rather than an full opposite as in the traditional investment theory. The aspect of risk between bonds and equities As already noted equities are considered to be of more risk and high potential returns. However, the bonds are considered to be of less risk and less returns. This partly explains why younger ages have concentrated on equities for both short and long term investment. However, after realizing that this is more risk over both the long term and short-tem, there is a shift towards more bonds in an individual portfolio of assets. Specifically, in the UK there exists great interest in augmenting corporate bonds holdings, both amongst pension funds and private investors (Imam, Richard, & Colin, 2008, pp. 493-499). These are considered to be safer than equities, whereas they provide a higher yield compared to government bonds. This is narrow thinking, considering that corporate bonds are not essentially ‘low risk’ strategy of investing in the long-term. It is true that corporate bonds yield far much better than Government bonds, nonetheless carry the risk of default. If the company fails, the same bondholders could still go at loss of a great proportion of capital (U.S. Securities and Exchange Commission, 2010). Therefore, shifting from equities to investing in corporate bonds carries the peril of holding equities, nonetheless may sacrifice longer-term better return that equities have the potential. Diversification of portfolio of assets in contemporary world A diverse range of assets offers a good opportunity for portfolio constructors for building wealth over time. Index funds be employed in capturing equities market movements, inflation-linked bonds can provided inflation safeguard, whereas hedge funds or hedge funds’ funds can offer absolute returns benefit that are not greatly correlated (or perhaps have no correlation) with other assets. Commodities and property can offer further diversification opportunities, as can venture capital (Gitman, 2000, pp. 88-89). Today derivatives (swaps, futures, or options) and hedging of currency are relatively easier to assist safeguard an individual’s wealth against losses arising from currency or market movements. The suggestion here is that for investors to maximize returns and build wealth over their course of time, must consider holding a good composition of diverse portfolio of assets that take advantage of low correlation of returns, to attain longer term growth as well as control of the portfolio. This implies that of late multi-period hedging methods will permit better management of currency and market risks over time, as compared to just depending on ‘time diversification’. Therefore, the contemporary environment in the UK provides for a more complex method that sees all the stages of lifecycle have a well-thought portfolio of assets than encouraging a particular formula of investment that might not hold the best in the day’s systems. Diversifying by alternative assets, such as hedge funds From 2000, investors of UK were forced to learn that over-relying on equities was a potential threat to their wealth and that investment risk has both positive and negative aspects with almost equal potential of operating (Economywatch, 2010). Nonetheless, as result of the benefit most of the investors realized from hedge funds, they are including hedge funds as a core portion of their investments in the long run. In essence, funds of hedge funds or hedge funds are optional methods of improving potential asset returns, whereas lowering the risk of the portfolio. They do not essentially increase the risk of the portfolio, as it is always the perceived; rather hedge funds have the goal of offering absolute returns and capital safeguard, with strategies that are lowly correlated or uncorrelated with bonds and equities (John Hancock Retirement Plan Services, 2010). They permit managers more flexibility and freedom to make money in the entire market conditions, either by benefiting from successful relative value anomalies exploitation between dissimilar assets, or benefiting from falling markets via going short. Like any other investments product, a manger’s skill is vital in determining performance, however, this is particularly the situation with hedge funds. A thorough observation of the performance of hedge funds as compared to equities show that they do not operate on the extremes whether during a downside or an upside, which means in the long-run they perform better in terms of, returns. This makes them an important option of investment in a given diverse portfolio. The importance of the goals of investment over the life-cycle of an individual It is important to underscore that an individual having more capital to invest should do so by taking into account a complete set of assets to invest at all stages (Slater & Olson, 1996, pp. 42-45). This stems from the fact that different phases in an individual’s life-cycle can involve different allocations of investment, but no one particular approach can exclusively fit all. It ideal to invest in arrange of assets including hedge funds over the life-cycle instead of concentrating on bonds even as they near leaving active employment. Today risk management methods are there to assist achieve better, risk-adjusted long term returns as well as enable individuals build wealth, with decreased volatility of returns over time. Today multi-period hedging methods that consist of a wide range of time periods and assets are available for helping in making investing decisions as compared to relying on standard ‘mean-variance’ optimizers (Osteryoung & Constand, 1992, pp. 47-49). As a way safeguarding against downside effect portfolios of individuals can employ derivatives at the entire life-cycle stages. Under this arrangement investors profit from developments done in fund management and banking industries, employing more complex products for wealth creation in the long term, but with superior control of risk. Maintaining well-calculated diversification of investment On the basis of liquidity and volatility it is possible to classify available option of investment. With this in mind, it becomes clear that there is no assurance that more volatile or risk assets will result into higher returns, although that is the expectation, so as to pay for the ‘risk’ assumed by the investor. Nonetheless, as noted above this risk operates on two extremes (Downside and upside), that may cause difficulties for the investors who depend squarely on any one class of asset (Economywatch, 2010). Concentrating solely on low volatility as well as highly liquid assets may mean an investor is sacrificing long-term returns that in turn threaten building of future wealth. Nonetheless, concentrating on high volatility as well as less liquid assets may imply that the wealth accumulated by an investor are vulnerable, sometime somewhere, if the volatile assets are going through a negative time of returns. The ultimate decision on the appropriate portfolio of assets depends on an individual investor but with this understanding one can pick one class of these assets without ignoring the other. Conclusion The market situation today provides arrange of options for investment for both corporations and individuals. At the same time, systems of capital and funds management have been developed significantly that the traditional life-cycle approach may not be an appropriate option today even though it is workable. Nonetheless, the three phases of life-cycle as identified have been and are applicable in UK only that the orientation to the new developments is needed (John Hancock Retirement Plan Services, 2010). Under the new arrangement individual can benefit from contemporary techniques that employ multi-period hedging, options and swaps, in identifying more optimal portfolios for delivering consistent returns as well as build wealth in a more reliable way over the life-cycle. It becomes obvious that depending on equities, even at younger phases, involves assuming a great deal of volatility, necessitating the adoption of a range of assets at all life-cycle phases. Investors need to be alert, ensure a more balanced and diversified portfolio for the success of long term investment. A range of assents and a range of holdings consisting of equities, property, fixed income and optional assets like private equity and hedge funds – is always best at all phases of life-cycle. When any action happens in favor or disfavor of specific assets the portfolio should be re-examined to keep profits under control or within the portfolio. With the instruments available for making investment decisions and cushioning against any adversities, the younger phase can now make an appropriate asset mix in the investment portfolio (Isberg, 1998, pp. 4-5). At the same time, those in the middle phase can adjust slightly from the first phase asset mix without losing focus. And finally, the last stage can still adjust further, but gradually to ensure that invest in a balanced diverse portfolio so that they do not sacrifice any returns nor avoid risk or volatility in its entirety as this can cause loss of capital or potential returns in the long term. Reference list Brigham, E. F., & Houston, J. F. (2001). Fundamentals of Financial Management. London: Harcourt Publishers, pp. 73-77. Carter, B., & MCGoldrick, M. (2005). The Expanded Family life Cycle: Individual, Family, and Social Perspectives . London: An Allyn & Bacon Classics, Pp.46-7. Economywatch. (2010, November 23). Investment Options. Retrieved January 29, 2014, from Economy Watch: http://www.economywatch.com/investment/investment-options.html Gitman, L. J. (2000). Principles of Financial Management. New York: Addison Wesley Publishers, pp. 88-96. Green, J. (2011). Thrift Saving Plan: Lifecycle Funds. New York: Jonh Wiley & Sons, pp. 57-63. Hawawini, G., & Viallet, C. (1999). Finance for Executives. New York : South-Western College Publishing, pp. 102-111. Imam, S., Richard, B., & Colin, C. (2008). The Use of Valuation Models by UK Investment Analysys. European Accounting Review , 493-502. Isberg, S. C. (1998). Financial analysis with the Du Pont ratio: A useful Compasss. Credit & Financial Management Review , 1-5. John Hancock Retirement Plan Services. (2010, May 10). John Hancock Retirement Plan Services Enhances the Lifecycle Suite by Offering Participants Both 'To' and 'Through' Lifecycle Choices . Retrieved January 29, 2014, from PR Newswire: http://www.prnewswire.com/news-releases/john-hancock-retirement- plan-services-enhances-the-lifecycle-suite-by-offering-participants-both-to-and- through-lifecycle-choices-101373389.html Loton, T. (2011). The Life Cycle Of An Investment. Investing , 12-21. Osteryoung, J., & Constand, R. (1992). Financial ratios in large public and smal private firms. Journal of Small Business Management , 47-56. Slater, S., & Olson, E. (1996). A value-based Management system. Business Horizons , 48-52. U.S. Securities and Exchange Commission. (2010). Mutual Fund. New York: U.S. Securities and Exchange Commission . Read More