Friday, June 24, 2011

Lifetime Financial Advice




Integrating Mortality Risky, Financial Risk and Longevity Risk in a Lifetime Financial Advice

A financial advice coming from a travel professional is uncommon and risky; but this one is based on sound principles so you can be rest assured. The framework for this ‘free ki advice’ is based on four parameters and an interplay between them – the level of financial wealth an individual possesses, the earning capacity of the individual in the future, the amount of insurance coverage required and the risk that an individual can assume with his current financial wealth.



We often consider financial capital to be the only wealth that we have. Our total wealth in fact comprises of our financial capital and human capital. Financial wealth is the total of all financial assets that we have accumulated including assets like real estates and share holdings in privately controlled businesses. Human capital is the present value of our anticipated earning over our remaining life time or in other words human capital is what we are expected to earn in our remaining working life. So the total wealth is financial plus human capital.



 
In the initial stages of our working life, we normally have very low financial capital and large human capital as we are expected to work for long and our earning capacity is likely to increase. Also as we earn and start accumulating financial capital (or converting human capital into financial capital) our financial capital increases and human capital decreases. As we retire our human capital is negligible, there may be some human capital left in the form of pension payments etc, otherwise the bulk of our total capital comprises of financial capital.

The next theme is the riskiness of both financial capital and human capital and how our investing decisions of financial wealth need to consider the effect of human capital.



A private investor basically faces three types of risks – i.e. mortality risk (or the risk of death and loss of income stream for the dependents), financial risk (risk of loss of value of financial assets due to market movements) and longevity risk (or outliving one’s financial assets). Mortality risk can be hedged with appropriate level of insurance (the universal life insurance policy) which is perfectly negatively correlated to the investor’s human capital. If one pays at the end of the year the other does not. If the insured is in the living state, the insurance expirers unclaimed and in the event of death, insurance coverage covers the loss of human capital (provided the full amount of human capital is insured). Thus mortality risk can be hedged away with appropriate insurance (and paying the premium).


 
The financial risk is the risk of fluctuations in the value of the financial assets due to movements in the market. The financial risk can be reduced by diversifying the financial assets and assuming less risk. The financial assets can be diversified by considering human capital as a part of the overall wealth (or total wealth). If the human capital is not risky (or employment is same and is not correlated with market movements) the investor can assume more risk with his financial capital or invest his financial assets aggressively in risky assets. The overall wealth will be more efficiently invested and the overall risk will come down.

The longevity risk or the risk of outliving one’s financial assets can be hedged with lifetime payout annuities which can either be fixed lifetime payout annuities and variable lifetime payout annuities. In fixed annuities the payment one receives over the risk of his life is fixed in nominal terms. Thus in fixed annuities inflation is not priced in and the real value of the annuity payments may fall in a high inflationary environment. In variable annuity payments are in the form of a fixed number of units of a particular fund. The value of the unit if derived by means of an NAV much like mutual funds or SIPs


 
Thus the take away from this reading is that hedge your human capital or what you are likely to earn in the rest of your life with adequate life insurance so that your dependents are not left unsecured in the unlikely event of death. Also hedge your human capital with adequate medical and disability insurance. Diversify your financial wealth by considering the riskiness of your human capital. For example a university teacher with less risky human capital should invest his financial wealth more aggressively in risky assets like equities and alternative assets. In comparison a stock broker whose income is tied up to the movements of equity markets has risky human capital and should thus invest less in risky assets and assume less risk by investing his financial assets in low risk investments like government bonds etc. Lastly, longevity risk needs to be hedged by purchasing a combination of fixed and variable lifetime annuity products. If the retirement corpus of an investor is large enough, the requirement of annuity products may not be required. But not all are lucky to have a large enough corpus at retirement. So plan for your retirement and plan in advance.

Thursday, June 23, 2011

Why the Lokpal Bill may prove to be a 'band-aid' solution?



Why the Lokpal Bill may prove to be a 'band-aid' solution?

Regulators never want to get regulated. Avoiding being avoided by the general public they have little respite from the flurry of chappals, sandals, boots and ‘fasts’ in dilly dallying the Lokpal Bill which in principal regulates the legislators but in practice is likely to change little in light of corrupt intent and bounded self control on the part of ‘powerhouses’ in the public domain.

There is some consensus in the ‘civil society’ on the need for a Lokpal Bill and Anna gets thumbs up for leading the movement and mobilizing public opinion in favor of the bill. But does it solve the problem it is being designed for? Will corrupt be less corrupt and will the bill prevail on the people who are part of its designing process? I doubt and it’s not because I am being pessimistic; but I’m rather being realistic.


Why do we need a Lokpal in the first place when we have an independent judiciary? Is it because we want to conduct enquiries and hold accountable the public servants outside the judicial process? Is it because we believe the Lokpal will be more independent, fair, unbiased and swift in dealing with matters related to corruption. Judiciary (at least in its theoretical context) qualifies on all three parameters of independence, fair and being unbiased but it fails miserably on the last parameter of acting swiftly. Once the matter gets sub judice, everyone can take a pillow and sleep. It would take an eternity to pronounce judgment even in cases which are crystal clear.

The making of Lokpal bill itself has proved to be quite a slug fight between the government and the civil society representatives. But even that being set aside I have a problem with the way civil society representatives were appointed on the Lokpal panel. Anna fasted for Lokpal , and people supported it but you can let him dictate his representatives on the panel if he fasted for it. A broad based representation from a cross section of the society would have been better.



Another question that is left unattended is who appoints the Lokpal and what the provisions for his removal are? It is so easy for those who will be covered under Lokpal to have the remote control for appointment / removal of Lokpal in their hand. Also they may deliberately try to keep the Lokpal understaffed to overburden them with work and thus less effectiveness.

The movement against corrupt is not what I have problem with; rather it’s the loopholes Lokpal will be unable to plug that bothers me. I believe comprehensive judicial reforms are more likely to provide a long term and sustainable solution to changing the overall landscape of social security and increasing accountability in India including addressing problems like corruption and tax evasion etc. For if the judiciary continues to delay justice, band-aid measures like Lokpal will lose steam soon.







Wednesday, June 22, 2011

Using economic information in forecasting asset returns



Using economic information in forecasting asset returns

Cash and Equivalents

  1. Longer maturities and lower credit ratings reward the extra risk with higher expected returns
  2. Managers lengthen or shorten maturities according to their expectations of where interest will go next
  3. Normally longer maturity papers will pay a higher interest rate than shorter maturity papers even if overnight interest rates are expected to remain the same, because the risk of loss if greater for the longer term paper
  4. If he thinks the economy is going to improve, so that less creditworthy instruments have less chance of default, he will shift more assets into lower rated cash instruments.
Nominal Default Free Bonds

  1. Yield is composed of a real yield and the expected inflation over the investment horizon
  2. The investor with a short term time horizon will focus on cyclical changes in the economy and changes in short term interest rates
  3. Higher expected economic growth results in higher yields because of anticipated greater demand for loan able funds and possible higher inflation
  4. An increase in short term interest rates increases medium and long term interest rates, but medium and long term interest rates may also fall if the interest rate increase is considerable to sufficiently slow down the economy
Credit Risky Bonds

  1. Corporate Bonds
  2. Risk Premium = Yield on corporate debt – Yield on treasuries with similar maturity
  3. During recession the credit risk premium increases because default is more likely
Emerging Market Government Bonds

  1. Most emerging market debt is denominated in non domestic currency
  2. Default risk for foreign currency denominated bonds is higher
Inflation Indexed Bonds

  1. TIPS
  2. These bonds are both credit risk and inflation risk free
  3. If inflation start rising, the yield on these bonds will fall, as demand for these bonds increases
Common Stock

  1. Value of an asset is PV of future cash flows
  2. Earnings and risk adjusted required return are important
  3. Short term growth is affected by the business cycle
  4. In a recession, sales and earnings decrease. Non cyclical or defensive stocks are less affected by the business cycle and will have lower risk premiums and higher valuations than cyclical stocks
  5. Cyclical stocks are characterized by high business risk and / or high fixed costs
  6. In early expansion phase, stocks are rising because sales are increasing and input cost are fairly stable.
  7. Later on in the expansion input costs start to increase and earnings growth slow, interest rates also increase during late expansion which is a further negative for stock valuation
  8. P/E ratios are high in an early expansion period when interest rates are low and earnings prospects are high. They decline as earning prospects decline. For cyclical stocks P/E ratios may be quite high in a recession.
Emerging Market Stocks

  1. Historical returns for emerging markets stocks are higher and more variable than those in the developed world and seem to be positively correlated with business cycles in the developed world.
  2. The correlation is due to trade flows and capital flows
Real Estate

  1. Real estate assets are affected by interest rates, inflation and the shape of the yield curve and consumption.
  2. Interest rates affect both the supply of and demand for properties through mortgage financing rates.
  3. They also determine the capitalization rate used to value cash flows