Thursday, April 20, 2006

Financial planning

I have been interested in investments and finances for a long time. I have read enough and studied enough to manage my own investments more effectively than a professional financial planner could do, and much less expensively. I have written my own portfolio optimization program and designed an improved system for portfolio distribution. I am well versed in the theory and mathematics of asset allocation, Modern Portfolio Theory, Efficient Market Hypothesis, and various equity pricing models. But occasionally something comes along which revolutionizes the way that I look at finances. When it does, I will pass it along to you, the handful of readers of this blog.

The revolution is a new way of doing lifetime financial planning: consumption smoothing. Larry Kotlikoff, professor of Economics at Boston University, used this concept to create the most comprehensive financial planning tool available today, Economic Security Planner. At $200 it is not cheap, but compared to the ongoing cost of hiring a financial planner and paying his loads, commissions, and fees for the rest of your life, it is a bargain. And the value of the advice from ESP is likely to be far greater than from a member of the financial industry sales force.

The principles behind consumption smoothing are not new. They have been studied by economists for decades. But until now, the computing power and software required to apply the theory to an individual family's financial situation did not exist. Considerations such as the impact of taxes, social security, and uncertain future investment returns make the problem very computationally intensive. Conventional financial planners use one-size-fits-all rules of thumb which typically do more to pad the planner's pocketbook with larger commissions than to serve the needs of the customer. Being off by even a few percent can cost thousands of dollars over your lifetime.

The concept is simple: to create a plan which avoids sudden large changes in standard of living. These changes could take many forms: reaching retirement age without enough in savings to maintain your previous standard of living, or reaching retirement with way more money than you need, encountering large expenses like college costs without enough money saved, or the death of a spouse. ESP helps an individual create a lifetime financial plan including things like:
  • How much should I save?
  • How much should I put in my 401k?
  • How much can I spend this year without putting my future in jeopardy?
  • How much life insurance should I have?
  • What asset allocation should I use?
  • Will I be able to pay for my kid's college?
  • When can I afford to retire?
  • What should I do now to minimize the impact of taxes over my lifetime?
  • What are my priorities for saving?
  • Will my family be secure if I die?

Without something like ESP, you are left to guess at the answers to these questions, and being off by even a small amount can result in big financial disruptions in the future. ESP is the most comprehensive tool available to individuals to help them make these important decisions.

For a full discussion of consumption smoothing and ESP, read this paper by Kotlikoff.

(I do not profit in any way from the sale of this product. All disclaimers apply.)

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