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Script (Note: stock photos were used for the graphs displaying French stocks performance and historical inflation, and as a result they may not reflect actual historical data):
I’m Ramon Cuenca, founder and director of Art and Finance, the website that makes learning Finance fun and accessible
Last episode, we got our feet wet with Personal Finance and learned about the Investment Policy Statement, or IPS for short, which is a good framework to understand Personal Finance. Now, let’s focus on the first part of the IPS, the return objective.
(Episode #3: Personal Finance Basics: Return Objective)
OK, so in constructing our IPS, we need to specify a return objective. A return objective? Don’t we all want as high a return as possible on our assets? Why should we set a specified return objective?
The main reason is because of risk. As we previously learned, when it comes to investing, a higher reward involves higher risk. Depending on your situation, you may or may not be able to handle more risk than others. But wait… what does risk mean, anyway? Well – this is actually a hotly debated topic in the Finance community, so we’ll talk more about it in the following episode. But for the sake of simplicity, let’s just say risk means the chance of losing your money.
Back to the return objective. How do you determine it? Simply put, the return objective is the percent return from your investable assets required to help achieve your financial goals. We can determine this with what’s called an after-tax cash flow analysis, where we PLAN out future income and expenses, including taxes. Whatever shortfall, meaning expenses that are greater than income, that occurs from this analysis is funded with your investable assets. We define investable assets as either cash or assets that can easily be converted to cash, such as stocks and bonds – in other words, assets that are liquid.
Here’s a very simple example of an after-tax cash flow analysis.
Say you want to buy a Porsche in Year 2 – the car would cause your expenses to be greater than your income, and therefore you need to use your investable assets, which in this case are all cash, to generate the extra return of about 5%. Note that you need to add expected inflation into your return calculation! And the average tax on your portfolio as well, but we assume this is zero for the sake of simplicity. So we need to make a 5% NOMINAL return (which is real return plus inflation) off our investable assets in Year 2. How do we do it?
Here’s how: asset allocation. Asset allocation is choosing which asset class to invest your cash in and in what proportion. So, in this case, how much you should allocate to stocks or bonds. Note that cash earns you next to nothing, so we’ll exclude it from our example.
Here’s a quick snapshot describing the characteristics IN GENERAL of these two different categories of assets, also known as asset classes. Bonds are less risky, but the returns are lower, while stocks are riskier but have a higher return. To find out why, let’s take a look at what stocks and bonds actually are.
Bonds are debt that companies or governments issue, normally with the intention of paying interest. Stocks, also known as equity or shares, represent a unit of ownership of the actual company. When a company earns revenue, it must first pay bondholders before stockholders, because it legally owes bondholders interest and principal. IF it has some extra cash leftover after paying for all other necessary expenses, then the company pays stockholders a dividend.
A similar situation occurs for companies that go bankrupt. In the case of a liquidation of its assets, bondholders have a claim on the assets before stockholders do.
So, as you can see, bonds have lower risk because income is more certain for bondholders. On the other hand, if you own stock in a company, you are effectively an owner of that company and can benefit from the company’s earnings, which could potentially grow at a quick pace, often reflected in rising stock prices and/or dividends. Furthermore, companies tend to pass on price increases to their customers, meaning that stocks are generally better at beating inflation than bonds. But since earnings are hard to forecast, stock prices are often more volatile than those of bonds.
I’d like to emphasize that this situation is the general case for stocks and bonds, but is not always true. For example, you’re probably safer buying the stock of a blue-chip company that pays a steady dividend than buying the bond of a company that’s about to go bankrupt.
Going back to our example, for the sake of simplicity, let’s assume that bonds are forecasted to return 2% this year, while stocks are expected to return 10%. In this case, to get a 5% return, you need 62.5% of your cash in bonds, and 37.5% in stocks.
Obviously, this is a very unrealistic example, but it’s a good exercise to understand the sort of thinking you need when considering returns from asset classes. Realistically speaking, you probably are not going to leave it to the unpredictable financial markets to give you the return needed to fund a planned expense. Most people invest in stock and bonds for the long-term, and in that case, a 60/40 portfolio – 60% in stocks to provide growth and inflation protection over the long term, and 40% in bonds for some income – is a widely-recommended approach.
That wraps up our video on the return objective. See you next time when we delve more into asset classes and talk about risk!
Ramon Rodrigo Cuenca, CFA
Art and Finance
Assistant: Mack Agbayani
CFA Curriculum Level III, 2011, volume 2, pp. 113-115