Fixed Income Fund NAV determinant: Simplified

Assume last year inflation rate is at 3%. You bought a 6% coupon bond with $ 10,000 which repays you in 2 years. So your real net return was (6-3) = 3% annually. 


This year, inflation rate goes up to 6%. . No one wants to buy the same bond you have now for $ 10,000 because the real net return is 0%. 

How much insurance one really needs?

A case study based on Total Needs Approach:

Say, Mr Lim, aged 35, earns $ 100k annually. He is married with a 3 years old son.  Should he dies, he wants his family to have an annual income of $ 60k for the next 25 years, with the first payment due his death. He also needs to ensure his son is provided with at least $ 150k for his tertiary education in 15 years time. His biggest debt includes his house mortgage with $ 250k outstanding amount. His wife is also working and will be able to service the house mortgage with her salary.

Stark Reality: Child Education Costs & The Endowment Policy

Create Now, Save Later
So I read a reader contributed article (Personally Speaking by Hazel Leong) in Personal Money Sept issue, on why she felt that generic endowment insurance plan is insufficient to meet her child's education funds requirement in 20 years. 


The key takeaway here: Guaranteed lump sum rate of return in 2 decades time is even less than the current risk-free rate of return for Fixed Deposit of 3.15 percent.

In Excel, use the formula: Rate(20,4800,0,-120000) and you get 2%. 

And she further illustrates that an engineering degree currently costs about RM 150,000, with the assumption that the cost of education doubles every 10 years. I do not know how she came up with RM 150,000; but it could not be anywhere in local public or private institutions. An engineering degree at Multimedia University, my Alma mater, is currently tagged at RM 50,000. Therefore, let's take this as baseline for calculation below. Overseas studies are really, the privilege of the rich, and they are not any man on the street like the rest of us. Moreover, there are factors such as exchange rate fluctuation which we could not anticipate in the future, so let's be realistic and keep things simple.

*assume the education doubles every decade

Second key takeaway here: Endowment plan payout in 20 years can only fulfill one third of your child's education cost plus living expenses in the same timeline.

Now, the contributor advocates properties investment but I am not going into details of her plan here although it is very ideal if you have the cash for at least 10% down payment of the properties value, plus other closing costs.  Whatever the investment vehicle, everyone has their own preference. Just be prudent to balance the risk versus return.


Anyway, below are my estimation of the investment needed now to cover education cost of RM 370k.

Save  Now, Create Later

If anyone starts to allocate RM 10k today into investment vehicle of your choice with moderate return of 6 percent per annum, with yearly top up of RM 9.6k, he or she will be able to cover his/her child education cost in 20 years. 

RM 9.6k per year translates to setting aside RM 800 per month, with father and mother each contributing RM 400. Do-able right?

And you still have surplus of RM 14k, which can be used as down payment for your child's first car when he or she starts working after graduating.

Bear in mind this is only for one child. What if...

a) You have more than one child?

b) You child desire to study medicine, and he/she is capable of - you don't want to kill their dreams right?

Securing a scholarship though, is an added bonus. But I will only using EPF Account 2 for children education as last resort, because it will surely jeopardize my retirement plan.

The Downside of Active Self Investment

There is no insurance element in it, unlike endowment plan. The insurance component of endowment plan will provide the insured amount compensation to the proposer (parent) in the event of death or total permanent disability of the child. I do not think this is critical. On the other hand, if the proposer passes away/permanently disabled/suffers from any of the 36 critical illlness, the policy will sponsor the child until maturity.

To mitigate the risk of parent not able to provide financially to their child, any parent should be sufficiently insured. Like my previous CFP facilitator mentioned, if you love your family, and being the primary income earner, you should buy more insurance for yourself, NOT for your spouse/children. I am not expert in this, but probably after CFP Module 2 this semester, I could analyze total insurance needs more objectively.

Disclaimer: I am not an insurance agent.

Who am I?

An advocate of financial literacy :)

The Cause & Effect of Business Cycle

Coming from a non-financial background, it took me a while to put together all the pieces of what I knew. This should be the simplest flowchart to explain the business cycle if you are not an investment banker. Let me know of any blunders.

Click to enlarge

Lesson 1: Annual Percentage Rate vs Annual Effective Rate - Can you differentiate?

Statement of the Day : Understand that banks are sneaky

When a product provider quotes an interest rate, it is not always immediately apparent how much you will be paying - or be paid - if you take out the product.

Einstein said it best - 'if you can't explain it simply, you don't understand it well enough'.

Finance firms love selling complex products. That way customers don't know what they're buying, won't understand the potential downside risks, or realise the true costs, many of which will be expertly hidden in the small print.

Bank profits are big because as Andrew Ellson, Personal Finance Editor of The Times, perfectly sums up:

 "All Banks employ every trick in the book to disguise the true cost of almost every financial product they sell"

Let's get to this 2 terms before I illustrate examples in my subsequent posts.

Annual Percentage Rate (APR) 

• Also known as nominal rate or simple interest rate per annum
• Does not take into account the effect of intra-year compounding

Anticipating the price of goods in "n" years

Approximate this by calculating the Future Value, FV using financial calculator or excel.

Say, GSC  movie ticket at RM 10.00. Ignoring personal inflation rate, we take CPI increment of 3% per year, in 10 years.

In Excel, type "=fv(", then you will key in "0.03" for "rate", "10" for "nper" which mean n number of periods, "0" for "pmt" which stands for periodic payment, and "-10" for "[pv],  present value for which it must be negative.

You will get the answer RM 14.80. This is the expected movie ticket price in 2022 if inflation remains constant each year.

Cost Push vs Demand Pull Inflation

These are the 2 types of inflation. I can assure you that you and me have definitely encountered these on daily basis, albeit indirectly.

Cost-Push Inflation = a decrease in aggregate supply

Cause

a) Increase in labor and overhead cost

b) Increase in raw material prices as they become more scarce

Explanation
Because the production costs have increased, producer has 2 choices - either to produce less quantity, or decrease wage rates to retain the price, while still remains profitable. The former is usually not desirable.

Unfortunately, when wage rates cannot be reduced anymore, while the same volume or more is needed, consumer will have to bear the cost of this price increase.

The indicator for this is Producer Price Index (PPI)

Examples

1. Iphones and Ipads are being outsourced for mass production at Foxconn China due to low labour cost.
2. Manufacturing plants for US companies are set up in Penang instead of in the States because comparatively, salary paid to an equivalent job level will be higher in the States.
3. Surge in timber demand and prices post Japan tsunami

************************************************************
Demand-Pull Inflation = an increase in aggregate demand

Cause

a) Increase in money supply

b) Increase in price level of goods in the rest of the world

Explanation
Increase in money supply has to do with consumer spending. When more people can afford and willing to purchase goods, the available supply in the market become lesser if production output cannot keep out with increasing demand. When something become scarce, only the highest bidder can possess it. From the seller perspective, he can afford to sell his goods at a higher bargain price.
The second causes has to do with diminishing purchasing power of a nation relative to the rest of the world. It means if our foreign exchange rate (and economy) is weak, it would cost us more to buy imported goods.

Examples

1. Land is scarce in the Penang island, yet, more people desire to stay in Penang as the population grows. As a result, housing developers can charge a premium selling price for landed properties.
2. An imported item from United States will cost more in 2009 when the exchange rate is RM 3.50/U$ compared to current home currency of RM 3.00/U$.

OPR, BLR & Inflation - The Correlation

BLR, or Base Lending Rate, quoted in percentage, simply put, is the cost of borrowing money from financial institutions for any man in the street.

For house buyers and buyers, this all seem familiar - you want the lowest interest rate for your mortgage loan. However, at any given time, BLR is fixed, so the only variable in this equation is the percentage discount (BLR minus) or premium (BLR plus) from the BLR rate.

Overnight Policy Rate or OPR refers to the interest rate at which a financial institution lend liquid funds (immediately available money) to another financial institution overnight. This rate is determined by central bank, as in Malaysia, Bank Negara Malaysia during its Monetary Policy Meeting and it is a standardized rate for which banks can access short-term financing from central bank depositories.

The BLR is adjusted in correlation to OPR. The cause and effect of OPR adjustment is vast in terms of micro and macro economics, but suffice for this post here to illustrate the direct factors and effects.

Hike in the cost of borrowing has the intention of slowing down consumer demand & spending in a overheated economy, usually characterized by a steadily increasing inflation rate, uptrending share market and business activity. Example, the recent 25 bps in OPR translates into 35 bps in BLR at 6.60%.

Malaysia Consumer Price Index

So you always read about the inflation rate reported in the news, such as here.

How those numbers are computed anyway?

Every month, the Department of Statistics will actually publish the Consumer Price Index or CPI to reflect the changes of price for various categories of items. Different categories of items have different weighting, and then there is percentage change month over month, year over year.

I am sure that you realize, sometimes the price of food at your local eateries does not conform to this official survey. Well, I would say, use this as a reference only when taking inflation rate into any financial planning endeavour.

Personal Inflation Rate

This is perhaps a more important measure for comparing if your income increment matches your desired lifestyle.

Example, it really does not help if the overall reported annual inflation rate is 3% but you choose to obtain hire purchase for a more luxurious car every year. Your monthly commitment will increase, hence the income increment is quickly negated in this case. Then again, a vehicle is still a liability instead of an asset, we are knew that.

In a nutshell, personal inflation rate largely depends on the type and amount of your expenditure. Live modestly is my motto. I could have easily upgraded to a smartphone, just for the pleasure of it but no thanks, unless my good old Nokia stupid phone goes kaput, I do not think I need a new handset for now :)


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Inflation adjusted salary increment

Is our salary keeping up with inflation rate?

Say, if your annual salary increment is 10 percent, and inflation rate is at 4 percent, then the 'effective salary increment' is actually calculated as such:

[(1 + percentage increment) / (1 + inflation rate)] - 1

In this example, it is 5.77%. It reflects your real increment after removing the effects of inflation.

This is the accurate way to do it instead of  doing an approximation : (10 - 4 ) = 6 percent.