Heuristic and other Approaches to Asse ...
Heuristics, also known as rules of thumb, are simplistic and generic rules that... Read More
An economic balance sheet builds on the idea of a traditional balance sheet that many readers are likely already well acquainted with. The economic balance sheet pertains to individuals and families and goes beyond physical assets to include human capital, planned bequests, and other intangible assets. The idea in doing so is to plan out the adequacy of core capital and to view the sustainability of both desired spending levels as well as planned bequests. The traditional balance sheet is a great place to begin, but ultimately does not speak to the sustainability of lifetime spending compared to current assets and earnings potential.
$$ \begin{array}{l|r|cl|r}
\textbf{Assets} & & & \textbf{Liabilities} & \\
\underline{\textit{Financial}} & & & \text{Credit Card Debt} & 7 \\
\text{Current Assets} & 40 & & \text{Mortgage on Residence} & 40 \\
\text{Investment Accounts} & 140 & & & \\
& & {^\ast} & \text{Primary Capital} & \\
\underline{\textit{Non-Marketable}} & & & & \\
\text{Primary Residence} & 65 & {^\ast} & \text{Planned Bequests} & \\
\text{Vested Corporate Pension} & 135 & & & \\
{^\ast \text{Government Pension}} & & & \textbf{Total Liabilities} & \bf{47} \\
{^\ast \text{Private Pension}} & & & & \\ \\
{^\ast \textit{Human Capital}} & & & & \\ \\
\textbf{Total Assets} & \bf{380} & & & \\ \\
\textbf{Net Wealth} & 333 & & &
\end{array} $$
According to the traditional balance sheet above, the family in this example appears to have a positive net worth (at 333). However, after adding in the items that were not included on the traditional balance sheet (those marked with a \(\ast\)), another story emerges on the holistic balance sheet.
$$ \begin{array}{l|r|cl|r}
\textbf{Assets} & & & \textbf{Liabilities} & \\
\underline{\textit{Financial}} & & & \text{Credit Card Debt} & 7 \\
\text{Current Assets} & 40 & & \text{Mortgage on Residence} & 40 \\
\text{Investment Accounts} & 140 & & & \\
& & {^\ast} & \text{Primary Capital} & 387 \\
\underline{\textit{Non-Marketable}} & & & & \\
\text{Primary Residence} & 65 & {^\ast} & \text{Planned Bequests} & 200 \\
\text{Vested Corporate Pension} & 135 & & & \\
{^\ast \text{Government Pension}} & 35 & & \textbf{Total Liabilities} & \bf{634} \\
{^\ast \text{Private Pension}} & 4 & & & \\ \\
{^\ast \textit{Human Capital}} & 15 & & & \\ \\
\textbf{Total Assets} & \bf{434} & & & \\ \\
\textbf{Net Wealth} & \bf(200) & & &
\end{array} $$
This family has a negative net wealth when all assets and liabilities, and desired spending are considered. A negative net wealth means that based on current financial status, spending or bequests are not sustainable. This family may choose to scale back their lifestyle, compromise on planned bequests, or attempt to increase income. Either way, a more robust analysis, such as that of the holistic balance sheet, affords a chance for a more thorough analysis.
Over time, an investor's economic net worth will change as they age in their careers and in their economic life. While young, HC will dominate, and FC will be small. This trend will reverse over time. Real estate and other tangible assets may also dominate in the early years. This often gives way to larger pension assets and other FC as an investor ages.
The curriculum offers the following framework for individual risk management:
product. Choosing a risk management strategy requires consideration of both the magnitude of the risk and the options available to address it. Managing the risks identified by HC and FC involves choosing between one of the following options for each risk:
There is no requirement to purchase an insurance product when there is a risk exposure. A risk management strategy should consider the magnitude and range of options available to address the risk.
Question
All else equal, a young investor in the education stage of their economic life, most likely has the highest values of which of the following?
- Real estate.
- Human Capital.
- Equities.
Solution
The correct answer is B.
Human capital tends to be high for young investors as they enter the workforce. Since human capital is the present value of future income, it makes sense that this would naturally be highest when workers are just beginning in their profession and have their whole careers ahead of them.
A and C are incorrect. Real estate and equities are both assets that this investor will acquire over their working career as they turn human capital into financial capital.
Reading 9: Risk Management for Individuals
Los 9 (d) Describe an economic (holistic) balance sheet