The Life Cycle and Financial Intermediation

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Chapter 6

• The Life Cycle and Financial Intermediation

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Chapter 5The Life Cycle and Financial
Intermediation
Savings

20s to 30s
50s to 60s
Age
-
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Key Principles to Keep in MindBurton Malkiel

• History shows us that risk and return are
  related.
• The risk of investing in common stocks and bonds
  depends upon the length of time the investments
  are held. The longer an investors holding
  period, the lower the risk.
• Dollar-cost averaging is a useful technique that
  can further reduce the risk of stock and bond
  investment.
• You must distinguish between your attitude toward
  and your capacity for risk.

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Risk and RewardTotal Annual Returns for Basic
Asset Classes, 1926 - 94
Risk Index Average Annual (Year - to - Year
Volatility Return of Returns) Small company
stocks 12.2 34.6 Common stocks in
general 10.2 20.3 Long-term bonds 5.4 8.4 U.S.
Treasury bills 3.7 3.3 Inflation rate 3.1
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Asset Allocation

• Depends on stage in the personal financial life
  cycle
• Depends on personal capacity for risk
• Excludes special projects (saving for home)
• Usually distributed across three asset classes
  although there is opportunity to vary risk and
  return in each category
• cash
• bonds
• stock

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Age Mid - Twenties

• 5 - Cash
• 25 - Bonds
• 70 - Stocks

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Age Late 30s to early 40s

• 5 - Cash
• 35 - Bonds
• 60 - Stocks

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Age mid 50s

• 5 - Cash
• 45 - Bonds
• 50 - Stocks

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Age Late 60s and Beyond

• 10 - Cash
• 60 - Bonds
• 30 - Stocks

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Caveats

• A specific need must be funded with specific
  assets dedicated to that need
• ie. A down payment for a home that is to be
  purchased within five yearsuse GICs within one
  year use CDs.
• If you have a low tolerance for risk, adjust the
  portfolio to more conservative instruments
• Dont ignore opportunities (ie. High real rates
  of return in early 90s when stock returns had
  modest prospects.)

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Financial Intermediation

• Task Force on the Future of Financial Services
• Banks - Schedule I and Schedule II
• Trust Companies
• Insurance Companies (Life and PC)
• Investment Dealers
• Mutual Funds
• Credit Unions/Caisses Populaire
• Finance Companies (Ford Credit, GMAC)

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Intermediation Services of FIs

• risk transfer, reduction, and monitoring services
• liquidity services
• maturity intermediation services
• transaction services
• financial information services

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Deficit-Saving Economic Unit
Surplus-Saving Economic Unit

• Borrowers
• borrow large sums
  (mortgages/commercial/ personal loans)
• for long periods of time
• complex legal transactions because of the
  long-term nature of the debt contracts and the
  need to contractually ensure that the interests
  of the lender are protected.

• Savers
• many of them saving small amounts individually,
  but large amounts in aggregate
• for short periods of time (ie. Need liquidity)
• are generally risk averse
• dont have the capacity, time or sophistication
  to analyze risk or to monitor borrowers

Deposit-taking Financial Intermediary
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Deficit-Saving Economic Unit
Surplus-Saving Economic Unit
Deposit-taking Financial Intermediary

• Deposit-taking FIs
• pool deposits, provide liquidity for depositors,
  collect/analyze/monitor the financial
  positions/activities of borrowers, make credit
  allocation decisions among opportunities to
  lend/invest, negotiate/monitor/enforce loan
  agreements.
• In this manner the need of both savers and
  borrowers are met with efficiency. In the
  absence of FIs failure, confidence in the system
  is built and this encourages full participation,
  thereby reducing monetary leakage.currency in
  circulation is made available for the best
  competing uses in our society.

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Institutional Aspects of Special-ness

• money supply transmission (banks)
• credit allocation (banks, trusts, credit unions,
  and finance companies)
• risk offlay (insurance companies)
• intergenerational transfer (pensions, life
  insurance companies, and deposit-taking FIs)
• payment services (banks, trusts, and credit
  unions)
• denomination intermediation (mutual funds,
  pension funds)

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