The year 2008 ushered in one of the most challenging economic periods in U.S. hi
ID: 2612339 • Letter: T
Question
The year 2008 ushered in one of the most challenging economic periods in U.S. history. The effects of prolonged unemployment and reduced asset values for homes and personal wealth continue to affect people’s potential to realize their personal wealth objectives.
Identify two concerns that individuals should address in developing their own personal financial plan related to lessons learned from the risks identified during the recent U.S. financial crisis. What approaches should be included in a personal financial plan to address and minimize future risks with respect to these concerns?
Explanation / Answer
The first objective of a personal finance plan should be to insulate the individual against external shocks as much as possible.
Two concerns related to this objective are:
1. The income from the portfolio goes down or becomes zero
2. Future value of the investment comes down below the targeted minimum value.
To address the first risk, the individual has to identify and quantify her minimum acceptable monthly income level require for basic sustenance and other necessities. This is the threshold below which monethly income cannot drop.
Once this threshold is identified, the asset manager (portfolio manager) has to be informed of the objective. Accordingly, the asset manager has to be instructed on not allowing investment of riskier assets like balloon investments or start-up IPOs. It has to be kept in mind that this approach is for the risk-averse, loss-fearing individuals who want to protect their regular income. Risk taker investors can burden high risk assets anticipating higher returns.
The second concern comes from the inflation level. A high level will inflation will erode the purchasing power of money and decrease the real amount of money. However, nominal interest rates paid by financial institutions or rates at which an investment is compounded do not take inflation into consideration. So, to protect the real value of investment as not to let the future real value fall down below the current level, risk averse investors can invest in inflation-adjusted bonds, like TIPS (Treasury Inflation Protected Security) which provides a cushion against soaring inflation value.
These approaches are, of course, in response to the two concerns mentioned in the answer. There can be many other concerns that varies across individuals and the approaches on addressing such concerns would also vary.
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