Embed Size (px)
Citation preview
1
Chapter 4
Household Finance
2
Chapter Goals
Understand household finance and its economic and financial underpinnings.
View the household as a functioning enterprise. Recognize the many similarities between a household
and a business. Start to apply business thinking to PFP. Put into use in personal financial decision making cost of
time and life cycle theory principles. Differentiate various types of household outlays. Begin to understand personal financial planning theory
and Total Portfolio Management (TPM).
3
The Household Structure
Household: an organization of one or more people who live in the same dwelling and share financial and other resources intended for the well-being of its members.
The household is the principal organization intended to handle the financial and other personal activities of one or more people and to foster achievement of their goals.
4
The Household Structure, cont.
The household comes in many organizational forms, which influence its financial, legal, and tax situation.
For example, financial efficiencies can result from a multiperson household through:– Reduction in income fluctuation, – Specialization of task, and – Economies of scale.
A breakdown of alternative household structures and their effect on financial, legal, and tax matters is shown on the next slide.
5
The Household Structure, cont.
6
The Household Structure, cont.
Household formation has changed since 1950:
7
Theory: An Introduction
Theory underlies the personal financial planning process.
However, theories don't usually give a complete representation of how people act.
In many cases, the assumptions made seem unrealistic. Theory leaves out parts of reality in order to simplify key points that will help us understand deeper aspects of behavior.
With theory, we can attempt to explain why people do what they do.
8
The Theory of Consumer Choice
The theory of consumer choice describes the method by which people select goods and services to satisfy their needs.
People don’t have enough resources to purchase all goods and services.
Each person has certain preferences. Faced with a host of preferences and limited
resources, we make purchase decisions designed to maximize utility.
Utility: The satisfaction an item presents. Maximization: Getting the most possible from an
activity.
9
The Theory of Consumer Choice, cont.
People group goods and services into consumption bundles and rank the bundles in order of attractiveness.
Consumption bundle: The most attractive combination of goods and services.
We naturally select the bundle that provides us with the greatest enjoyment given our budget constraint.
Budget constraint: The limit on the amount we can consume.
10
The Theory of Consumer Choice, cont.
Savings allow us to consider multi-year consumption bundles.
Savings in the theory of choice represents future spending.
Our choices in a more realistic multi-year time frame are made by considering all current and future consumption bundles as compared with current and future wealth.
11
The Life Cycle Theory of Savings
The life cycle theory of savings shifts from the theory of choice’s hard-to-measure utility to concrete money terms.
The life cycle theory of savings assumes that utility can be measured in money terms.
It says that our spending decisions are based on the total amount we expect to earn over our life cycle.
Once we have established our lifetime resources, we try to maintain a constant level of expenditures throughout our life cycle.
The simple form of the theory assumes that risk and inflation are not present and that people act logically to pursue their goals.
12
The Life Cycle Theory of Savings, cont.
According to life cycle theory, borrowing generally takes place early in the household’s life, when income is low.
Then, as the income rises, people pay off their debt and save for retirement.
In retirement, when work-related revenues have stopped, savings would be liquidated steadily to maintain their cost of living.
At death there would be no assets remaining.
13
The Life Cycle Theory of Savings, cont.
Demonstration of the life cycle theory:
14
The Theory of the Firm
According to the economic theory of the firm, the firm is an organization that produces goods or services.
The goods it offers are sold to households at a price established in the marketplace.
The business concentrates on revenues (output level) and costs (inputs) in order to find the optimum level of production that maximizes profits.
Operating costs are split into those that are fixed and the remainder that vary with the level of production.
Profits are revenues minus nondiscretionary (fixed) and discretionary (variable) costs.
15
The Cost of Time
Gary Becker, an economics professor, employed a money framework to develop a theory of the cost of time.
Households and the people living and working in them are limited in the amount of money they can spend.
People are also limited in the time they have available.
16
The Cost of Time, cont.
Our time can be viewed as being spent either in work-related or leisure activities.
To decide how much time to devote to each, we: – Compare the utility we receive from leisure time
with that from the money we receive from work time.
– The fewer our leisure hours the greater its pleasure. – The higher the wage rate the more enticing is
further work. The preference for work over leisure or vice versa at
any level will vary from one person to another.
17
The Cost of Time, cont.
We also perform other activities that can be viewed as making us fit for work.
When we engage in any activities that don’t provide us with money, we can say we have an opportunity cost of time.
Opportunity cost of time: The amount of money we could have made if we had worked instead.
Normally, this cost of time would be our hourly wage or its equivalent.
By placing a money value on our non-earning time we can better evaluate efficiencies in many areas.
18
The Household Enterprise
According to traditional economic theory, the household is merely a supplier of labor to business and a purchaser of its goods.
But in many ways the household resembles a small business.
The household produces goods and services for its own consumption by combining items purchased with the time it takes to process it.
The cost is that of items purchased plus the opportunity cost of the time.
19
The Household Enterprise, cont.
We combine business-related costs with capital goods expenditures with our time at work.
The resulting product manufactured, our services, is sold in the marketplace for a salary or hourly fee.
Some activities add directly to revenues. Others support revenues by keeping us healthy and
ready to provide our best in the time we allocate to work.
The rest of our time and money is devoted to activities that we enjoy doing.
20
The Household Enterprise, cont.
Enterprise: An entity that engages in certain tasks for an end result.
Household enterprise attempts to run the household as efficiently as possible in order to provide as much time and money as possible for pleasurable activities.
21
The Household Enterprise, cont.
Household production can be described as follows:
22
The Transition to Finance
Thus far we have dealt primarily with economics, as economics has historically been the principal provider of broad-based information about household resources.
Until now, there is no integrated theory of household finance or personal financial planning.
Instead, most work in finance has concentrated on marketable securities such as stocks and bonds and on research on businesses and financial markets.
Our objective is to set forth an integrated theory of personal financial planning.
23
The Transition to Finance, cont.
We can relate the relative emphasis placed on various factors by finance and economics:– Practicality: Finance places more stress on practicality
in its analysis.– Cash Flow: Finance describes most processes in
tangible money terms.– Portfolio Solution: A portfolio is a grouping of assets.
Finance is able to look at how those assets interact so as to provide an integrated solution to a problem.
– Risk-Return Analysis: Finance more often incorporates risk in decision making and can offer outcomes in combined risk-return terms.
24
Household Finance
Household finance: The financial counterpart of the household enterprise.
The goal of household finance is to have the cash flows of a household’s members run as efficiently as possible, given its financial and nonfinancial objectives.
The household has three kinds of day-to-day financial activities: – Revenue producing (e.g., jobs and investment
income),– Overhead (maintenance) costs, and – Leisure outlays.
25
Household Finance, cont.
Overhead costs include: – Costs that directly support jobs such as commuting
costs and business lunches; – Housing-support costs such as mortgage interest and
utility expenses; and – Personal support costs such as eating, nonbusiness
clothing, and personal care. Leisure outlays include all non-work, non-overhead
related items such as eating out, watching television; playing tennis, and shopping for non-necessities.
26
Household Finance, cont.
Capital expenditures: Cash outflows that provide household operating benefits over an extended period of time.
Grouping capital expenditures with daily costs can distort our analysis of the financial performance for the year.
Because they have ongoing worth, capital expenditures are a form of investment.
Other investments such as stocks, bonds, and free cash flows, are also treated separately.
27
The Household as a Business
Many object to limiting household goals to the business goal of making the most amount of money possible.
Yet few disagree that money is one of the significant factors in achieving personal goals.
Segregating daily outflows into maintenance and leisure expenditures can help to identify the similarities between a household and a business.
28
The Household as a Business, cont.
The household’s resemblance to a business can extend to profits and dividends.
– Business profits that get paid out to owners for their choice of use are called dividends.
– Household cash flows after overhead charges are the equivalent of business profits.
Viewing the household as a business implies that its activities are more complex and its decisions more logical than many people acknowledge.
While people may respond emotionally, so do business people.
29
The Household as a Business, cont.
The similarities between the household and a business are as follows:
Household finance Business finance Income Revenues from work-
related output reflected in salary and pension + investment returns
Revenues from output of goods and services + investment returns
Expenses Nondiscretionary expense Fixed and variable cost Cash flows after maintenance expenses
Profits - Amount available for current and future needs
Profits
Additions to investments Savings reserved for future use
Reinvested earnings intended to help generate future dividends
Leisure outlays Cash to be distributed currently to member-owners for their use for pleasurable activities
Cash to be distributed currently to stockholders for their use
30
Modern Portfolio Theory (MPT)
Three key principles of Modern Portfolio Theory (MPT) are as follows: – Investments should be viewed as part of a portfolio,
not individually.– When deciding whether to purchase an investment,
don’t look at return alone; look at return in relation to risk.
– Overall risk is influenced by the degree of diversification among assets in the portfolio.
MPT is generally limited to marketable financial investments such as stocks and bonds.
31
The Theory of Personal Financial Planning
We construct a theory of financial planning through a number of statements, summarized as follows:
1. PFP Goal: The overall goal of PFP is to enjoy the highest standard of living possible.
2. The Life Cycle Approach: Life cycle theory provides an appropriate model of individual actions.
3. Household Structure: The household is the appropriate overall structure to represent one or more people, goals and operations.
4. The Household Enterprise: The household manufactures goods and services for internal and external use. Its objective is to become as efficient as possible.
32
The Theory of Personal Financial Planning, cont.
5. Household Finance: Household finance represents the structural counterpart of personal finance.
6. The Household Portfolio Approach: The household can be viewed as a portfolio, an accumulation of assets and liabilities that can be expressed as a portfolio that uses a MPT approach, with a broader group of assets.
7. The Portfolio Solution: The goal in financial terms is to run the portfolio as productively as possible through obtaining the highest return for the risk we undertake.
8. PFP Goal Achievement: PFP is the analysis and implementation arm of household finance. By generating the highest cash flow possible, household portfolio optimization satisfies the PFP goal of enjoying the highest attainable standard of living.
33
Total Portfolio Management (TPM)
Total Portfolio Management (TPM): the active arm of personal financial planning theory.
All of our assets and obligations form the household portfolio.
The returns we receive on this portfolio are our “profits.”
Our household financial projections of revenues and expenses are made on a long term basis as broadly structured by life cycle theory.
34
Total Portfolio Management (TPM), cont.
TPM’s focus is to provide the highest return possible on the household portfolio, given our resources and risk preferences.
The TPM approach attempts to select the best mix of assets to achieve the household’s objective.
TPM is not dependent on the validity or lack of appropriateness of any one practical interpretation of its principles.
Instead, it is the veracity of the overall approach that counts most.
The TPM approach unique is its use of all household assets and obligations.
35
Behavioral Financial Planning
Behavioral finance is the human side of money. For example, sound financial planning often advises
that you begin to save money for retirement as soon as you start working.
Yet many young people postpone retirement saving, preferring enjoyment today over retirement concerns.
Behavioral financial planning closes the gap between actual and ideal planning, thereby bringing people closer to their own goals.
36
Summary of Personal Financial Planning Theory
Theory of choice + Life cycle theory
Household as organization
Household production theory
Household enterprise
Household portfolio
Total portfolio management
Portfolio returns
Personal financial planning goal achievement
37
Chapter Summary
The household is the organizational structure that incorporates all of a person’s or group’s financial activities.
The household signifies logical financial actions and in the case of two or more members, it draws their personal financial planning objectives together.
The household is a functioning enterprise. Its stress on having efficient operations and generating the highest cash flows for the time allocated to work brings to mind a business.
Household finance is the financial counterpart of the household enterprise.
38
Chapter Summary, cont.
The opportunity cost of time provides a dollar amount for time spent on non money producing activities.
The life cycle theory of savings has strongly influenced personal financial planning.
Household outlays can be separated into nondiscretionary and discretionary outlays. We try to minimize nondiscretionary outlays and increase discretionary outlays.
Personal financial planning theory is an integrated overall approach to decision making for household finance. It uses Total Portfolio Management as its underpinning.
