Chapter 15. Financial Planning and Investments

Many of the financial decisions that individuals have to make in their personal lives such as choosing a mortgage, investing their savings, and planning for retirement require using financial models. However, the models are developed and used most of the time by others (for example, financial planners) on their behalf. In this chapter we will develop a few such versatile models. They illustrate additional applications of the concept of the time value of money and also involve investing and taxation.

Review of Theory and Concepts

Let us start by reviewing a few basic issues that many personal finance models involve. We will then discuss two alternate approaches to retirement planning and an approach to structuring investment portfolios that we will use to develop several models.

SOME BASIC ISSUES

Inflation

Inflation is one of the key factors that has to be incorporated in many models for making personal finance decisions, especially when long-term planning is involved. If you are saving money to buy a car three years from now, inflation may not be an important factor. But if you are 30 now, plan to retire at age 65, and expect to live until you are 90, inflation must be factored into the models you use. For example, it is impossible for any of us to guess how much we will need in nominal dollars per year during retirement—it may be 35 years away. However, we may be able to say more comfortably that we will need in today's dollars (also called ...

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