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MIS 4500 (31)
Lecture 19

Lecture 19.docx

3 Pages

Management Info. Systems
Course Code
MIS 4500
Pourang Irani

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Lecture 19: Lifetime Financial Advice: Human Capital, Asset Allocation, and Insurance Human Capital: economic PV of investor’s future labor income  early life stages: financial and investment capital should hedge and diversify human capital  implications of model: o younger investors invest more in stocks than older investors o investors w/ safe labor income invest more in financial portfolio in stocks o investors w/ labor income that is highly correlated w/ stock markets invest their financial assets in less risky assets o ability to adjust labor supply increases as investor’s allocation to stocks  labor income typically has low correlation w/ stock market n  HC(x)  E[h t tx11 r  vtx  Human capital as a risk-free asset: invest in stocks and gradually scale back as gets older  Human capital as a risky asset: 1. if correlated w/ other risky financial assets, buy risk-free asset when young and gradually move to risky-assets (as risky human capital declines); 2. if not correlated w/ other risky financial assets, same as case 1.  Impact of initial financial wealth: greater percentage allocation to risk-free asset (b/c initial wealth reduces portion of wealth that is safe human capital)  Correlation b/w wage growth rate and stock returns: make greater allocation to risk-free asset Implications for Advisors: 1. investors should invest financial assets to diversify and balance human capital 2. young investor w/ safe human capital should invest more financial assets in risky assets than older 3. if human capital correlated to risky assets, reduce allocation to risky assets Mortality risk:  asset allocation and life insurance decisions should be made jointly  life insurance is perfect hedge of human capital in event of death  optimal amt of insurance depends on: 1. expected value of human capital and 2. risk-return characteristics of the insurance contract.  life insurance (θ) optimization: x,xE 1 D 1 q U x alive x1 H x1 D q Ux deadW x1 x i. q is subjective probability of death ii. U is utility function  as correlation b/w shocks to income and risky assets increases, optimal allocation to risky assets declines and optimal quantity of life insurance declines (implies lower amt of human capital)  the more financial assets one has, the less optimal quantity life insurance  less risk tolerance, the more risk-free assets and the more life insurance  demand for insurance decreases w/ age (primary driver of life insurance is human capital) Retirement Portfolio and Longevity Risk:  goals: 1. comfortable life style and 2. bequests  risks: market risk; 2. longevity risk; and 3. risk of not saving enough (including effects of inflation) i. financial market risk: portfolio values fluctuate in short run, and may occur early in retirement  mitigate w/ diversification ii. longevity risk: outlive assets  hedge w/ insurance products: lifetime annuities / payout annuities 1. fixed: doesn’t account for erosion by inflation; typically can’t trade out of once purchased 2. or variable: fluctuates w/ performance of funds investor chooses  main sources of income: social security; DB pension plans; personal savings iii. risk of spending uncertainty: may not save enough to adequately fund retirement  behavioral issue  combination of types of annuitization and systematic withdrawals helps manage financial risks and income needs DC plans may be profit-sharing: based on plan sponsor’s profits  sponsor directed
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