Personal Finance (cont.)
TCH302
Lawrence J. Gitman, Michael D. Joehnk and Randy Billingsley (2011)
Personal Financial Planning, Chapter 8, 9, 10, 11
Learning objectives
Apply financial concepts in …
o Managing personal assets/ Allocation assets and investment
o Exploiting and managing personal insurance
o Declaring and managing personal income taxes
Personal finance planning
Personal finance planning process
1. Define financial goals.
2. Develop financial plans and strategies to achieve goals.
3. Implement financial plans and strategies.
4. Periodically develop and implement budgets to monitor and
control process toward goals.
5. Use financial statement to evaluate results of plans and
budgets, taking corrective action as required.
6. Redefine goals and revise plans and strategies as personal
circumstances change.
Allocation assets and investment
• Investment choices include exposure to the major and alternative asset
classes
• Risk and return trade-offs are inherent in all investment analysis
• In order to build a portfolio of investments the investor must have
appreciation of risk and return attributes
• The main investment classes are:
 Cash
 Fixed Interest
 Shares
 Property
Investor Attributes
• Investors are classified into various groups based on:
• Tolerance to risk
• Preference for income versus capital growth
• Investment timeframe
• Defensive investors are more risk averse and are focused on preserving capital
• Aggressive investors have more tolerance towards risk and focus on capital
growth
• Financial planners use these classifications to determine the appropriate asset
mix for their clients
Risk Profile
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A person’s age
Income
Wealth
Years to retirement
Past financial experiences
General Investor Attributes – By Classification
Considering diversification
• Returns on various assets are impacted by the broader economic environment
in different ways
• Diversification is owning/investing in more than one particular asset, and more
than one asset class.
• The goal of diversification is to minimise risk
Illustrating how diversification can reduce risk in a portfolio of shares
• For a portfolio of shares, we must consider the risk and returns of the whole
portfolio rather than just the return of the individual shares in the portfolio
• Portfolio risk is not simply a weighted average of the standard deviations of
individual shares in a portfolio
• It is necessary to understand the concept of correlation between the returns
on shares
• Correlation is the relationship between the return on one share compared to
the other share
• The correlation coefficient shows the extent of correlation among shares
Illustrating how diversification can reduce risk in a portfolio of shares
• The correlation coefficient shows the extent of correlation among shares
• It has a numerical value of –1 to +1 which indicates the extent of risk reduction
within a portfolio:
Negative correlation (–1) -> Large risk reduction
Positive correlation (+1) -> No risk reduction
Diversification Across Asset Classes
Investment strategy
• General Investment Strategies: Gibson (2000)* argued that holding four asset
classes in a portfolio (multiple-asset class investing) would reduce the risk of
the portfolio and increase its average return.
• This happens because the four asset classes are not strongly related to each
other:
• As one asset class performs well the others are less likely to perform as
well and as the better performing asset class reverses its performance the
other asset classes tend to perform better.
• The performances tend to counteract each other which provides for a
better long term average return and lower level of risk of such a portfolio.
* Gibson, R. C. (2004). The rewards of multiple-asset-class investing. Journal of Financial Planning, 17(7), 58.
Investor behaviour
• The traditional view is that markets are efficient and that investors are
rational.
• Some irrational behaviour observed:
• Loss aversion — prospect theory: investors dislike losses a lot more than
they like equal gains.
• Herding — people tend to follow crowd behaviour.
• Overconfidence — many investors mistakenly believe they can beat the
market resulting in overtrading and more losses.
• Biased judgements — ‘house prices never go down’.*
* Beaudry, P., & Willems, T. (2022). On the macroeconomic consequences of over-optimism. American Economic Journal: Macroeconomics, 14(1), 38-59.
Information Sources for Investment Choices
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Economic fundamentals
Industry characteristics and reports
Company background, prospects, annual reports
Current market prices
Government reports
Analyst reports
Using the internet as a search engine
Risk and risk management
Risk can be classified in a number of ways. One classification is speculative vs. pure risk
Speculative risk arises where there is a chance of a loss or a gain (eg. gambling or starting
up a business)
Pure risk arises where there is only a possibility of loss or no loss (ie. no chance of gain)
Can be personal, related to property, or as a result of liability
The risk management process is a systematic approach to the identification and
management of pure risks faced by individuals
Key stages in the process are:
 Identification and evaluation of potential risks
Possible losses and their costs
 Management of identified risks
Avoidance and minimisation
 Program review
To ensure ongoing protection
Insurance is the principal means of providing for serious losses
Insurance
• Insurance is based on the concept of pooling
• Pooling is where individuals contribute resources to a fund that is used to pay for
the adverse consequences suffered by some members of the pool
• The contribution to the pool is referred to as a premium
• There are three main categories of insurance
Life
General
• E.g. car, house, travel, business, indemnity, mortgage, workers’ compensation
Health
• Hospital cover or general (ancillary or ‘extras’)
Risk management
•Key stages in the process are:
Identification and evaluation of potential risks
Possible losses and their costs
Management of identified risks
Avoidance and minimisation
Program review
To ensure ongoing protection
Need to consider the threats and vulnerability to these
threats
Threats could be related to health e.g. premature death,
illness, injury
It could be related to property e.g. loss of home, car, contents
It could work related e.g. liability, business partner’s health
What is the likely financial consequences from the identified
risks??
Loss of income
Costs that will be incurred
Replacement cost
When the potential loss is large, insurance may be the only
option
When the potential loss is small there may be other
treatments available
Identification and evaluation of potential risks- Life insurance
• Financial consequences of death
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Funeral and associated expenses
Medical expenses
Mortgages
Other debts
Emergency funds
Taxes and/or legal costs
Who would be affected?
Those who are financially dependent
Degree of dependency
Single income
Two incomes
Needs of dependants
Young adults
Young families
Mature family
Calculation of Insured Needs
Risk management
•Key stages in the process are:
Identification and evaluation of potential risks
Possible losses and their costs
Management of identified risks
Avoidance and minimisation
Program review
To ensure ongoing protection
Risk avoidance: Avoiding an act that would create a risk.
Loss prevention: Any activity that reduces the probability
that a loss will occur
Loss control: Any activity that lessens the severity of loss
once it occurs.
Risk assumption: The choice to accept and bear the risk of
loss. => an effective way to handle many types of
potentially small exposures to loss when insurance
would be too expensive.
Transfer – passing financial responsibility to another party
by using insurance
Life insurance
Provides cover against the risks of premature death
Named beneficiary receives the proceeds and is safeguarded from the financial
impact of the death
Who would be affected by the client’s death?
To what financial extent would they be affected?
What would be the appropriate insurance cover?
E.g. Motor Vehicle and Risk management
•Key stages in the process are:
Identification and evaluation of potential risks
Possible losses and their costs
Management of identified risks
Avoidance and minimisation
Program review
To ensure ongoing protection
Damage to the vehicle itself
Loss or damage to third parties or their property
Control via car alarms, safety devices, etc.
Financing through insurance
Motor Vehicle Insurance
• Compulsory third party (CTP) – covers legal liability for
bodily injury to third parties arising out of the use of a
motor vehicle
• Full comprehensive insurance – covers damage to the
vehicle itself, as well as damage to third party’s property
• Fire, theft and third party property– covers third party
property damage plus limited coverage of insured vehicle
for fire and theft only
• Third party property – only covers damage to third party
property
Declaring and managing personal income taxes
In Vietnam:
Law on personal income tax, 2007
Amending and supplementing a number of articles of the law on
personal income tax, 2012
List of relevant regulations Personal Income Tax