Financial Planning vs. Financial Economics
The Lifecycle Model of Saving and Consumption
Aaron Stevens EC171, 24 May 2011
1
Financial Planning vs. Financial Economics Financial planning starts with goals: How much will that cost? When? What rate do you expect to earn on investments? …arrive at how much to save now
Financial economics starts with resources: What do you have? What are your obligations? How should you allocate your resources? Minimize risks to guarantee success
Two Period Model You are yo ung aEnadchyopuerw iod of ork.l ea n time , i r time, is 30 rougholy and d l e r a f u o o Y years ouulthdoieo.d. y ad 3
Budget Constraint: When Young
When you’re young, you work.
Cy +
S
=
What you earn (labor income)
Cy + S = W What you consume in your youth
What you save
Budget Constraint: Old Age When you’re old, you live on savings.
Co = S
Consumption when old
Amount saved when young
Lifetime Budget Constraint* It was for this work (in 1954) that Franco Modigliani won the Nobel Prize in Economics in 1985
Cy + S = W Co = S By algebraic magic: Co = W - Cy or Cy + Co = W *No Investment Return *No Taxes and/or Benefits
What’s on Your
Balance Sheet? List your assets on the left-hand side List your liabilities on the right-hand side (Don’t worry about exact amounts) What assets and liabilities did you list? What is your net worth?
Let’s Play Make Believe • What will your balance sheet look like in 20 years? • What is your net worth going to be? • Why? Does this balance sheet fairly represent your economic condition?
What is Value?
What is the value of this coffee table?
What is Value? Accounting practices describe different tools for valuing assets and liabilities: • Book value • Market value What is economic value?
Future Income How does future income show up on your balance sheet? Why? Human Capital is the asset which enables you to generate labor income. How much is your HC worth today? In 10 years? In 30 years? In 50 years?
A Millionaire At Age 22!
Joe Blow, age 22 Joe earns $42,000 per year Joe will work until age 66 (no taxes, interest rate = 0%)
Your Economic Net Worth Assets + Cash + Securities + Property = Total Conventional Assets
Liabilities - Short term debts - Long term debts = Total Conventional Liabilities
Conventional NW = Conv. Assets - Conv. Liabilities + Human Capital
Economic Net Worth = CNW + HC
Future Consumption What about future consumption? You’re gonna have to consume (eat, buy shelter, clothes, entertainment) for the rest of your life.
How much can you consume, over your lifetime?
Lifetime Budget Constraint Lifetime consumption is bounded by the Lifetime Budget Constraint: Cy + Co = W
Lifetime = CNW + Human Capital Consumption (wherein conventional net worth is assets minus liabilities)
Future Consumption is a Declining Liability
Joe Blow, age 22 There’s every chance Joe would live to age 100.
Risk: Outliving Your Money
Joe Blow, age 22 Since Joe will stop working at age 66, but he needs to eat until age 100...
Convert Human Capital to Financial Wealth During working years, accumulate financial capital to offset the declining value of human capital.
What’s the Secret? How do I become Wealthy? During working years, accumulate financial capital to offset the declining value of human capital.
The secret to becoming wealthy is that there’s no secret! Savings = Income - Consumption
What You Learned Today • Financial Planning vs. Financial Economics • Introducing the 2 period model and the Lifetime Budget Constraint • Economic Value • Human Capital • The Lifecycle Model explains the need to convert human capital to financial capital (a process called savings).
Announcements and To Do Readings:
• STTE, ch 1-2 (today) • ME, ch2.1, pp37-39 (today) • ME, ch2.1, pp41-44 (Monday)
QUIZ 1 is on Monday Homework 1: Estimate your human capital.
Aaron Stevens EC171, 24 May 2011
1
Financial Planning vs. Financial Economics Financial planning starts with goals: How much will that cost? When? What rate do you expect to earn on investments? …arrive at how much to save now
Financial economics starts with resources: What do you have? What are your obligations? How should you allocate your resources? Minimize risks to guarantee success
Two Period Model You are yo ung aEnadchyopuerw iod of ork.l ea n time , i r time, is 30 rougholy and d l e r a f u o o Y years ouulthdoieo.d. y ad 3
Budget Constraint: When Young
When you’re young, you work.
Cy +
S
=
What you earn (labor income)
Cy + S = W What you consume in your youth
What you save
Budget Constraint: Old Age When you’re old, you live on savings.
Co = S
Consumption when old
Amount saved when young
Lifetime Budget Constraint* It was for this work (in 1954) that Franco Modigliani won the Nobel Prize in Economics in 1985
Cy + S = W Co = S By algebraic magic: Co = W - Cy or Cy + Co = W *No Investment Return *No Taxes and/or Benefits
What’s on Your
Balance Sheet? List your assets on the left-hand side List your liabilities on the right-hand side (Don’t worry about exact amounts) What assets and liabilities did you list? What is your net worth?
Let’s Play Make Believe • What will your balance sheet look like in 20 years? • What is your net worth going to be? • Why? Does this balance sheet fairly represent your economic condition?
What is Value?
What is the value of this coffee table?
What is Value? Accounting practices describe different tools for valuing assets and liabilities: • Book value • Market value What is economic value?
Future Income How does future income show up on your balance sheet? Why? Human Capital is the asset which enables you to generate labor income. How much is your HC worth today? In 10 years? In 30 years? In 50 years?
A Millionaire At Age 22!
Joe Blow, age 22 Joe earns $42,000 per year Joe will work until age 66 (no taxes, interest rate = 0%)
Your Economic Net Worth Assets + Cash + Securities + Property = Total Conventional Assets
Liabilities - Short term debts - Long term debts = Total Conventional Liabilities
Conventional NW = Conv. Assets - Conv. Liabilities + Human Capital
Economic Net Worth = CNW + HC
Future Consumption What about future consumption? You’re gonna have to consume (eat, buy shelter, clothes, entertainment) for the rest of your life.
How much can you consume, over your lifetime?
Lifetime Budget Constraint Lifetime consumption is bounded by the Lifetime Budget Constraint: Cy + Co = W
Lifetime = CNW + Human Capital Consumption (wherein conventional net worth is assets minus liabilities)
Future Consumption is a Declining Liability
Joe Blow, age 22 There’s every chance Joe would live to age 100.
Risk: Outliving Your Money
Joe Blow, age 22 Since Joe will stop working at age 66, but he needs to eat until age 100...
Convert Human Capital to Financial Wealth During working years, accumulate financial capital to offset the declining value of human capital.
What’s the Secret? How do I become Wealthy? During working years, accumulate financial capital to offset the declining value of human capital.
The secret to becoming wealthy is that there’s no secret! Savings = Income - Consumption
What You Learned Today • Financial Planning vs. Financial Economics • Introducing the 2 period model and the Lifetime Budget Constraint • Economic Value • Human Capital • The Lifecycle Model explains the need to convert human capital to financial capital (a process called savings).
Announcements and To Do Readings:
• STTE, ch 1-2 (today) • ME, ch2.1, pp37-39 (today) • ME, ch2.1, pp41-44 (Monday)
QUIZ 1 is on Monday Homework 1: Estimate your human capital.
