To construct a portfolio, the investor starts by defining its purpose. There must be some goal (or goals) to guide the selection of the assets that should be included. After specifying realistic financial objectives, the next step is determining which assets are appropriate to meet the goals. After establishing investment goals and identifying assets that may meet the goals, the investor should determine the resources and sources of income with which he or she has to work. The investor then can construct a financial plan designed to fulfill the investment goals within the constraints.
The Specification of Investment Goals
The purpose of investing is to transfer purchasing power from the present to the future.
A portfolio is a store of value designed to meet the investor’s reasons for postponing the consumption of goods and services from the present to the future. Possible goals include the following:
1. The capacity to meet financial emergencies
2. The financing of specific future purchases, such as the down payment for a home 3. The provision for income at retirement
4. The ability to leave a sizable estate to heirs or to charity
5. The ability to speculate or receive enjoyment from accumulating and managing wealth In addition to these specific investment goals, many individuals have general finan- cial objectives that are related to their age, income, and wealth. Individuals go through phases, often referred to as a financial life cycle. The cycle has three stages: (1) a period of accumulation, (2) a period of preservation, and (3) a period of the use or depletion of the investor’s assets.
During the period of accumulation, the individual generates income but cash out- flows on housing, transportation, and education often exceed cash inflows, which in- creases debt. Yet individuals with debt (e.g., a mortgage, car payments, or student loans) often start the process of accumulating assets, especially by participating in tax-deferred
financial life cycle The stages of life during which individuals accumulate and subsequently use financial assets.
pension plans. Such participation, especially if the employee’s contributions are matched by the employer, may be one of the best investment strategies any individual can follow.
During the period of preservation, income often exceeds expenditures. Individuals reduce debt (e.g., pay off the mortgages on their homes) and continue to accumulate assets. The emphasis, however, may change to preservation of existing assets in addition to the continued accumulation of wealth. Since investors will need a substantial amount of wealth upon reaching retirement, they must continue to take moderate or prudent risk to earn a sufficient return to finance their retirement.
During the period when assets are consumed, most individuals will no longer have sal- ary or wage income. Even though a pension and Social Security replace lost income, many individuals must draw down their assets to meet expenditures. While the assets that are re- tained continue to earn a return, the amount of both risk and return are reduced as safety of principal becomes increasingly important. These individuals, however, continue to need some growth. A married couple, both age 65, have a combined life expectancy of at least 20 years. Such a long time horizon argues for the inclusion of equities in their portfolio.
An Analysis of the Individual’s Environment and Financial Resources
Financial planning requires an analysis of the individual’s environment and financial re- sources. 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. This may be done by constructing two financial statements. The first one enumerates what is owned and owed, and the other enumerates cash receipts and dis- bursements. The former is, of course, a balance sheet, whereas the latter is a cash budget.
Typical entries for a balance sheet are given in Exhibit 4.1, which considers the individual’s financial position currently and for some time in the future, such as at an- ticipated retirement or when a child will attend college. For the purposes of financial planning, individuals should both construct their current financial position and project what that position may be in the future. The projected balance sheet requires assump- tions such as (1) the ability to retire debt and accumulate assets and (2) the return that will be earned by the assets. Although the projections will depend on the assumptions, they often bring the individual’s financial needs into sharp focus and can help establish investment strategies.
The balance sheets in Exhibit 4.1 are less detailed than is necessary for financial planning, but they do illustrate the concept. The mechanics of constructing a balance sheet are relatively easy. The difficult part is enumerating the assets and placing values on them. Such valuation is easy for publicly traded securities, such as stocks and bonds.
The difficulty concerns placing value on tangible personal assets such as collectibles and real estate. Since the purpose of constructing a balance sheet is to determine the individual’s financial condition, it may be advisable to be conservative in estimating the value of such assets. If, for example, the individual had to sell antiques to finance living expenses, it would be better to underestimate than to overestimate the prices for which these assets may be sold.
After listing what is owned and what is owed, the next step is to construct a cash budget. A cash budget enumerates receipts and disbursements and may cover a period such as a month or a year. Exhibit 4.2 illustrates the entries needed for the construction
cash budget A financial statement enumerating cash receipts and cash disbursements.
ExhIBIT 4.1
A Simplified Balance Sheet for an Individual
Present Future AssETs
1. Bank deposits
a. Checking accounts _________ _________
b. savings accounts _________ _________
c. Certificates of deposit _________ _________
subtotal _________ _________
2. Liquid financial assets
a. Money market mutual funds _________ _________
b. Treasury bills _________ _________
c. Tax refunds and other payments owed _________ _________
subtotal _________ _________
3. Retirement and savings plans
a. IRA accounts _________ _________
b. Employee retirement accounts _________ _________
c. Employee savings plans _________ _________
d. Deferred compensation _________ _________
e. Company options _________ _________
subtotal _________ _________
4. Long-term financial assets
a. Treasury bonds _________ _________
b. Corporate bonds _________ _________
c. Municipal bonds _________ _________
d. Corporate stock _________ _________
e. Mutual funds _________ _________
subtotal _________ _________
5. Tangible assets
a. Real estate: home _________ _________
b. Real estate investment properties _________ _________
c. Automobiles _________ _________
d. Collectibles _________ _________
e. Personal tangible property _________ _________
subtotal _________ _________
Total Assets _________ _________
LIABILITIEs 1. short-term
a. Credit card balances _________ _________
b. Current portion of car loan _________ _________
c. Current portion of mortgage _________ _________
d. Other _________ _________
subtotal _________ _________
2. Long-term
a. Balance on car loan _________ _________
b. Balance on mortgage _________ _________
c. Other long-term debts _________ _________
subtotal _________ _________
Total Liabilities _________ _________
sUMMARY
Total assets _________ _________
Total liabilities _________ _________
NET Worth (value of estate; assets minus liabilities) _________ _________
ExhIBIT 4.2
A Simplified Cash Budget for an Individual
Present Future CAsh RECEIPTs
1. salary (after deductions) _________ _________
2. social security _________ _________
3. Pension _________ _________
4. Interest _________ _________
5. Dividends _________ _________
6. Distributions from retirement accounts _________ _________
7. Annuities _________ _________
8. Other receipts _________ _________
Total receipts _________ _________
Present Future CAsh DIsBURsEMENTs
1. housing
a. Mortgage payments _________ _________
b. Rent _________ _________
c. Maintenance _________ _________
d. Utilities _________ _________
e. Operating expenses _________ _________
f. Property taxes _________ _________
g. Insurance _________ _________
2. Personal expenses
a. Dining _________ _________
b. Personal care _________ _________
c. Automobile _________ _________
d. Clothing _________ _________
e. Recreation _________ _________
f. hobbies _________ _________
g. Other _________ _________
3. Medical expenses
1. Insurance _________ _________
2. Doctors _________ _________
3. Other _________ _________
4. Other cash disbursements
a. Gifts _________ _________
b. Contributions _________ _________
c. Estimated taxes _________ _________
d. Other sUMMARY
Total receipts _________ _________
Total disbursements _________ _________
Difference between receipts and disbursements _________ _________
of a simplified cash budget. It lists the individual’s sources of receipts (e.g., salary, interest income, and dividends) and the individual’s disbursements (e.g., mortgage payments, living expenses, and taxes). Like the balance sheet, the cash budget may be constructed for the present and projected to a specified time in the future.
If the individual’s receipts exceed disbursements, the excess becomes a source of funds that may be invested to finance future needs. If disbursements exceed receipts, more funds are spent than are received. This implies that the individual’s outstanding debts are increasing or assets are being consumed. Constructing the cash budget thus determines where funds are coming from and where they are going. This information should help the individual perceive ways to increase receipts and decrease disburse- ments, thus generating additional funds for investments.