Financial Planning: Goals, Asset Allocation, and Taxation

1. Chapter 3 Financial Planning

2. LEARNING OBJECTIVES • Identify possible financial goals. • Construct an individual’s balance sheet and cash • budget. • 3. Explain the importance of asset allocation to a portfolio’s return. • Identify the taxes that affect investment decisions. • Illustrate how capital losses are used to offset capital gains and ordinary. • Explain the importance of the speed of price changes to efficient markets.

3. LEARNING OBJECTIVES • Differentiate among the three forms of the efficient market hypothesis. • Describe several anomalies that are inconsistent with the efficient market hypothesis. • Differentiate between active and passive portfolio management strategies and the investor’s belief in the efficiency of financial markets.

4. Goals and financial life cycle • financial life cycle: The stages of life during which individuals accumulate and subsequently use financial as The cycle has three stages: (1) a period of accumulation (2) a period of preservation (3) a period of the use or depletion of the investor’s assets sets.

5. THE PROCESS OF FINANCIAL PLANNING Setting Goals Asset Allocation Taxation

6. THE PROCESS OF FINANCIAL PLANNING The Specification of Investment Goals: • The capacity to meet financial emergencies • The financing of specific future purchases, such as the down payment for a home • The provision for income at retirement • The ability to leave a sizable estate to heirs or to charity • The ability to speculate or receive enjoyment from accumulating and managing wealth

7. Individual’s Environmentand Financial Resources • Financial planning requires an analysis of the individual’s environment and financial resources. • One’s environment includes such factors as age, health, employment, and family. • In addition to environment, the investor should take an accurate account of financial resources. • The balance sheet • The cash budget

8. ASSET ALLOCATION • Asset allocation is the process of determining what proportion of the portfolio should be invested in various classes of assets which determined by • investment policy • market timing • asset selection

9. The Federal PersonalIncome Tax • Progressive • Tax rates (brackets) from 10 to 38.6 percent as of 2002 • The importance of the last (marginal) tax bracket • New law reduces tax rates over time

10. A Tax Shelter • Avoids taxes • Reduces taxes • Defers taxes

11. Examples of Tax Shelters • Tax-exempt bonds • Capital gains • Tax-deferred pension plans • Tax-deferred annuities • Life insurance • Employee stock option plans

12. The Most Important Tax Shelters • Tax-exempt bonds • Capital gains • Tax-deferred pension plans

13. Capital Gains • Are either short-term or long-term • Short-term is a year or less • Short-term capital gains tax rate: the investor's marginal tax rate

14. Capital Gains • Long-term is greater than a year • Long-term capital gains tax rate: 10 percent or 20 percent • Are only taxed once realized • May hold an asset indefinitely and avoid capital gain taxes

15. Capital Losses • Offset capital gains • The order of offsetting gains and losses: • first, short-term losses offset short-term gains • second, long-term losses offset long-term gains

16. Capital Losses • third, net short-term losses offset long-term gains or • net long-term losses offset short-term gains

17. Capital Losses • fourth, net short-term or long-term losses are used to offset income from other sources • $3,000 ($1,500) limitation • losses exceeding $3,000 ($1,500) are carried forward

18. Tax Deferred Pension Plans • Deductible (traditional) Individual Retirement Account (IRA) • Contribution limit: $3,000 annually of earned income • If not covered by a pension plan, contributions are deductible from taxable income

19. Tax Deferred Pension Plans • If covered by a pension plan, contributions may be deductible from taxable income (subject to earned income limitations) • Assets in the account: selected by the individual • Withdrawals: taxable

20. Keogh Account • For the self-employed • Contribution limit: 25 percent of income or $35,000 (whichever is smaller) • Effective contribution limit is 20 percent

21. Keogh Account • Contributions: deductible from taxable income • Assets in the account: selected by the individual • Withdrawals: taxable

22. 401(k) and 403(b) Plans • Plan offered by an employer • Participation by employee: voluntary • Contributions: deductible from taxable income

23. 401(k) and 403(b) Plans • Employer may match employee contributions • Assets in the account: chosen from alternatives determined by employer • Withdrawals: taxable

24. Non-deductible Roth IRA • Contribution limit: $3,000 annually • Contributions: not deductible from income • Assets in the account: selected by the individual • Withdrawals: non-taxable

25. Deductible Versus the Non-deductible IRA • Importance of the tax rate • when funds contributed • when funds are withdrawn • Different limitations • on income • participation in the plans • when funds have to be withdrawn

26. Tax-deferred Annuities • Contract for series of future payments • Contract purchased today • Income earned by the investment: • not currently taxable • taxable as withdrawn

27. Life Insurance • Difference between • face value • cash value • Growth in cash value not currently taxable • Death benefit: not taxable to beneficiary

28. Employee Stock Option Plans • Stock purchase plans: • must be offered to virtually all employees • generally the purchase price is lower than the stock's price • possible source of long-term capital gains

29. Employee Stock Option Plans • Incentive stock options: • granted to selected employees • purchase price: equal to current price (when issued) • possible source of long-term capital gains

30. Estate Taxation • Levied on value of the individual's estate • Progressive rates to 50 percent • Rates to decrease over time

31. Estate Taxation • Spousal exemption • Tax credit exempts under $1 million • Tax credit will increase • In 2010, estate tax is scheduled to be repealed

32. Corporate Federal Income Taxation • Progressive • Rates rise to 35 percent • Phase out of lower corporate rates • Most public corporations pay 35 percent

33. THE EFFICIENT MARKET HYPOTHESIS The efficient market hypothesis (EMH), which suggests that investors cannot expect to outperform the market consistently on a risk-adjusted basis. EMH assumptions: • There are a large number of competing participants in the securities markets, • Information is readily available and virtually costless to obtain • Transaction costs are small.

34. Random Walk • EMH hypothesis argues that a security’s price adjusts rapidly to new information and must reflect all known information concerning the firm therefore price follows a random walk • A random walk essentially means that price changes are unpredictable and patterns formed are accidental

35. Random Wlk • The price is determined by fundamentals Including earnings, interest rates, dividend policy, and the economic environment. Changes in these variables are quickly reflected in a security’s price.

36. The Speed of Price Adjustments • For securities markets to be efficient, prices must adjust rapidly. • GOOG example in 2006 If an investor were able to anticipate the earnings before they were announced, that individual could avoid the price decline.

37. Forms of EMH • Weak form • Semi strong form • Strong form

38. Weak form • The weak form of the efficient market hypothesis • Suggests that the fundamental analysis may produce superior investment results but that the technical analysis will not. • Thus, studying past price behavior and other technical indicators of the market will not produce superior investment results

39. Semi strong form • The semi strong form of the efficient market hypothesis asserts that the current price of a stock reflects the public’s known information concerning the company. • This knowledge includes both the firm’s past history and the information learned through studying a firm’s financial statements, its industry, and the general economic

40. Strong form • The strong form of the efficient market hypothesis asserts that the current price of a stock reflects all known (i.e., public) information and all privileged or inside information concerning the firm. • Thus, even access to inside information cannot be expected to result in superior investment performance.

41. Empirical Evidence for the EMH: The Anomalies • While the evidence generally supports the semistrong form of the efficient market hypothesis, there are exceptions. • Two of the most important anomalies are the P/E effect and the small-firm effect. • January effect • a day-of-the-week effect • The neglected-firm effect • The overreaction effect

42. Implications of the EMH • Active Vs Passive strategies Ultimately, you must decide for yourself the market’s degree of efficiency and whether the anomalies are grounds for particular strategies. Any investor who has a proclivity toward active investment management may see the anomalies as an opportunity. Those investors who prefer more passive investment management may see them as nothing more than interesting curiosities