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A tricky question

Sat 05 September 2009

, Henriëtte Prast, Tilburg University

Which would you prefer: 5 million euros in assets or 10 million euros in assets? Already made up your mind?

Then I’ll ask you the same question again, but this time with a bit more information.

Which would you prefer: 5 million euros in a financial environment in which the only investment possibility is a perpetual bond with a real interest rate of 10 percent, or 10 million euros in a financial environment in which you can only invest in perpetual bonds with a real interest rate of 1 percent?

Let’s do the math.

Based on the financial environment described above, the 10 million euros in assets will generate 100,000 euros in real income annually. The 5 million euros in assets with the corresponding interest rate of 10 percent will yield 500,000 euros in income annually.

Are you still sure you want to choose the 10 million euros? So the right answer to the question whether you would rather have 5 or 10 million euros is consequently: It depends. It depends on the financial environment and on what you want to use the money for.

If you hope to live off of it for the rest of your life, for your retirement for example, then the financial environment after the capital has been accumulated is hugely important. An environment with exclusively perpetual bonds obviously isn’t realistic. But this example does show that asset planning entails much more than just aiming for amount x on date y.

The question you must ask yourself is this: What standard of living do I want to maintain after date y and what do I have to do to achieve this?

The wisest route is to first think about what you absolutely do not want to give up. If you never want to leave the home you are living in now, then this is the living standard that you have to safeguard – no matter what happens in the financial markets. This means your mortgage must not be linked to the AEX index.

The moral of the story is that asset planning doesn’t start with financial knowledge, but with self-knowledge.

The focus is not on how much risk you are willing to take, but rather on what you never want to give up. This is why it is important to take a good long look at your inner self before you examine returns, volatility, investment products and risk/return ratios. It will make life a lot easier now and a great deal more enjoyable in the future.