Mortgage Choice : A Review of the Literature

Although it appears that a theoretical body of knowledge for the Financial Planning Profession has always existed, until recently theory was not often explored as such, and there was no written common understanding or agreement on the theoretical basis of the financial planning profession. A survey of the financial planning literature over the past 50 years was performed, and certain basic theories from many existing disciplines were identified, although their application in personal financial planning has sometimes resulted in modifications. The theories identified from the literature were compared with the financial planning educational topics list of the CFP Board of Standards and the core financial planning process was explored in detail. A definition of financial planning as values and goals-driven strategic management of the client’s financial resources was fashioned and the financial planning process as the strategic planning process applied to the financial and economic resources of the person or family was also defined. Financial planning has matured and grown more technical over the past decades. Although it appears that a theoretical body of knowledge has always existed, until recently theory was not often explored as such, and there was no written common understanding or agreement on the theoretical basis of the financial planning profession. In the study that follows, it becomes clear that the planner is using analysis of financial resources, internal and external environmental constraints and theories from many disciplines to devise a financial strategy. Literature in several of these disciplines was explored to identify theories that appear relevant to financial planning. A definition of financial planning as values and goals-driven strategic management of the client’s financial resources was fashioned, and the financial planning process was identified as the strategic Journal of Personal Finance 14 ©2008, IARFC All rights of reproduction in any form reserved. planning process applied to the financial and economic resources of the person or family. The financial planner emerges as an outsourced CFO for the individual or family enterprise. First, those financial planning articles that discussed financial planning theory per se over the past 50 years were examined chronologically and the theories suggested by those authors identified, articulated and compared to what is available in the financial planning literature. Next, the important core financial planning process was analyzed separately. Then the planning literature for each of the nine categories of financial planning expertise as defined by the CFP Board of Standards in its educational topic list (2005) was explored to identify, insofar as possible, the theories that contribute to that category. Articles Concerning Financial Planning Theory per se Few articles were found that identified themselves as discussing financial planning theory. The most comprehensive article appeared in American Economist (Altfest, 2004). Altfest traces origins of financial planning theory to Modigliani, Becker and Markowitz (among others) and to the classical economics of choice. Altfest pointed out that in the first half of the twentieth century, some economists started to apply classical economic theory to the management of the household, using the term “home economics.” Milton Friedman, in his Nobel Laureate autobiography, says this concerning his work in 1937: The catalyst in combining my earlier consumption work with the income analysis in professional incomes into the permanent income hypothesis was a series of fireside conversations at our summer cottage in New Hampshire with my wife and two of our friends, Dorothy S. Brady and Margaret Reid, all of whom were at the time working on consumption (Friedman, 1976, p. 11). Margaret Reid and Dorothy S. Brady are considered to be two of the leaders of modern home economics. In the 1930s, home economics started to focus less on domestic arts and more on consumption economics, although there are examples of financial planning in earlier home economics literature as well. Like them, many home economists were either professors of economics or government economists (Grossbard-Shechtman, 2001). Research in the Hearth archives in the Cornell library reveals many examples of early literature on financial planning. This early literature, despite the economics background of its authors, was largely pragmatic and did not concern theory. This background resulted in the long-standing inclusion of advice on consumer economics in Department of Agriculture programs, and financial Volume 7, Issue 1 15 R e s e a r c h & T h e o r y planning programs in the human sciences departments of universities. Yet, financial planning as the profession is currently seen, traces its origins to a meeting of financial services executives in Chicago in 1969. Thus, there are two traditions that contribute to financial planning today: one from the consumer economics field, and the other from the finance and financial services field. Becker and Decisions Within the Family Gary Becker taught at Columbia from 1957–1968 (Becker, 1993) before returning to the University of Chicago in 1969. He was a theoretical economist who applied economics to decisions within the family (Becker, 1974a, 1974b, 1988, 1992), calling it the New Home Economics. While Becker and the original home economists both looked upon the family as a production unit as well as a consumption unit, Becker was primarily concerned with the impact of family decisions on macroeconomics and national policy. The original home economists, however, in addition to conducting government studies on cost of living and expenditures, applied their chosen field of economics as a microeconomic exercise, seeking to maximize production and make the economic processes more efficient and profitable for the managers of that family. As noted by Altfest (2004), Becker added richness to the concepts of resource allocation within the family by his work on the allocation of time in non-work activities. While at Columbia, Becker (1965) postulated a basic theoretical analysis of choice that considers the cost of time on the same footing as the cost of market goods. He recognized that using the time of a member of the family was using a resource of production. He envisioned the family as a small factory that combines “capital goods, raw materials and labor to clean, feed, procreate and otherwise produce useful commodities” (Becker, 1965, p. 94). Since Becker was an economic theorist, in those early years he almost never did empirical work to confirm his theories, yet was quite definite in his ideas about the effects of decisions within the family on the national economy and society. Later Becker recognized that decisions within a family are often not unanimous, but are negotiated among family members on the basis of sometimes conflicting aims and cultural altruism (Becker, 1992). For instance, he claimed that the higher earning power of women outside the home was responsible for a decline in the family, since higher earnings by the woman made the choice to have children more expensive and the cost of her labor within the family higher. He considered the gender division of labor essential to the stability of the family (Becker & Tomes, 1986). Becker’s theories have influenced financial planning in several ways. For example, the economic value of the work of the homemaker, and conseJournal of Personal Finance 16 ©2008, IARFC All rights of reproduction in any form reserved. quent need for life insurance on the homemaker who does not earn a wage, originates in Becker’s ideas on time as a resource. His work on human capital and education decisions (Becker & Tomes, 1976) is evident in the almost universal assumption that parents want to save for their children’s educations. In more recent theoretical explorations, new concepts in financial planning concerning education not discussed in the classical economic literature include considerations of eligibility for financial aid and tax considerations, neither of which were considered when the focus was on the implications for public policy (Hogan & Kroeger, 2005). Modigliani and Friedman: Expenditure, Savings, and the Life Cycle Another early theoretical source for financial planning mentioned by Altfest (2004) was Franco Modigliani, who was awarded the Nobel Prize in 1985 for his work on savings and the life cycle. Modigliani postulated that decisions on consumption and savings were made by the individual consumer based on anticipated lifetime earnings and consumption, not just on that year’s needs (Modigliani & Brumberg, 1954). This premise would explain the almost universal consumption beyond their means by young people, not in terms of immaturity but in their high expectations. This hypothesis has farreaching implications for the national economy, one of which is that how much the population of a nation saves does not depend on actual national income, but on the public’s perceived rate of growth of national income, since it assumes its own income will grow accordingly. Milton Friedman in 1957 presented the Permanent Income Hypothesis, which is similar to Modigliani’s work. Subsequently, economists have tested this premise econometrically (Kotlikoff, Spivak, & Summers, 1982) with varying results, although most have tended to confirm it. A corollary of Modigliani’s life cycle premise is that the rise of Social Security benefits has been a contributing factor to the decline in savings in the United States since pension wealth tends to reduce savings (Attanasio & Brugiavini, 2003). This life-cycle view is the basic premise on which financial planning bases retirement planning, turning the premise from an economic theory of how people will naturally behave into a guideline. Textbooks in financial planning implicitly use Modigliani’s theory when doing capital needs analysis to determine the amount a client needs to save and invest for retirement (Dalton, Dalton, Cangelosi, Guttery, & Wasserman, 2003; Mittra, Kirkman, & Seifert, 2002). One difference in life cycle theory in economics and in financial planning is in perspective. Like Becker, Modigliani appears to have been more interested in the implications for macroeconomics and public policy than is a financial planner who is trying to maximize the utility of the economic and Volume 7, Issue 1 17 R e s e a r c h & T h e o r y financial resources of one client. An article that combines in its assumptions both Becker’s theories of decision making and Modigliani’s life cycle analysis with the pragmatic concerns of the practicing financial planner appeared in the Journal of Financial Planning in 2001 (Opiela, 2001). That article discussed the “tough choices” of saving for retirement and saving for college, and suggested that it was best to counsel saving for retirement. In 2004, a retrospective study of household income and retirement (Lahey, Kim, & Newman, 2003) indicates that the concept of life cycle consumption patterns is an entrenched part of retirement planning in financial planning practice. Furthermore, the determination in this study that 40% of post-retirement income is earnings of other family members is consistent with financial and economic theories of altruism and choice as proposed by Becker (1965). Those theories were sustained in a quantitative study of transfers of money and time within households (Schoeni, 1997). Thus the financial planning literature supports Altfest’s (2004) assertion that financial planning is firmly grounded in economic theory. Modern Portfolio Theory and the Capital Asset Pricing Model Modern Portfolio Theory (MPT) (Markowitz, 1952) is another foundational theory (Black Jr., Ciccotello, & Skipper Jr., 2002). MPT is a normative theory that asserts that investors should choose investments based on discounted future expected returns and that for maximum risk adjusted returns investors should diversify across industries and asset classes. The theory is simple, but application requires many variations and refinements to accommodate circumstances and can be quite difficult to achieve. An explicit application and implementation of MPT in personal financial planning appeared in 2001. It was a methodology for producing balanced portfolios using alpha, beta and R-squared statistics that was published in Financial Planning magazine (Israelsen, 2001). These three statistics are the cornerstones of most implementation of MPT. Foreshadowing today’s focus on income distribution in retirement, the express purpose of Israelsen’s methodology was to make it possible for an investor to always have a fund available for withdrawals that would be up in the current market, thus avoiding permanent loss of value due to bad timing (Israelsen, 2001). MPT was further refined by Sharpe and Tobin into the Capital Asset Pricing Model (CAPM) (Sharpe, 1964; Tobin, 1958). In the CAPM, meanvariance analysis by investors is assumed. The CAPM decomposes the risk of an investment into two kinds of risk, systematic and specific. In the CAPM, Sharpe said that the market does not reward specific risk, since specific risk can be offset by diversifying the portfolio. In contrast to the normative nature of MPT, the CAPM is a descriptive theory of equilibrium Journal of Personal Finance 18 ©2008, IARFC All rights of reproduction in any form reserved. relationships between expected rates of return and risk. Basically, the CAPM says that the premium return on an asset (the expected rate of return on the asset minus the rate of return of a riskless asset) is proportional to its beta, a measure of the sensitivity of a security’s rate of return relative to changes in the overall market. All investors seek to find the point of greatest return for their acceptable level of risk. The problem for financial planners is that the CAPM has some rather heroic assumptions, in addition to the assumption that the investor performs mean–variance analysis. It does not take into account taxation or transaction costs, is interested in securities over only one period, and assumes riskless borrowing. The CAPM was further refined (Black, Jensen, & Scholes, 1972) by empirical testing from which emerged a modification that did not assume riskless borrowing. Over time refinements have improved the model. In the financial planning literature, one discussion listed seven assumptions that should be remembered when applying the CAPM (Oviatt, 1989). This theory and its refinements, particularly a widely-quoted article that asserts that 90% or more of the return of a portfolio is due to the allocation among asset classes (Brinson, Hood, & Beebower, 1995), were fully accepted in the finance community and form the foundation of many decisions in institutional investment, asset allocation and portfolio management. However, Markowitz (2005) himself has recently challenged the ascendancy of the CAPM, saying that it is based on unrealistic assumptions and that when those assumptions are replaced by ones that more closely reflect the real processes of the market the results are less dramatic. While some recent articles using three-factor theory (Pollock, 2007) tend to confirm asset allocation as the primary driver of investment performance, there are also challenges to the fundamental conclusions of the Brinson, Hood and Beebower article (Jahnke, 2003), so the jury is still out on active vs. passive management. For example, choosing the location of certain classes of assets in different accounts based on their tax status has been shown to yield 20 basis points higher return than the common practice of allocating the asset classes equally across a person’s or family’s multiple accounts (Daryanani & Cordaro, 2005). Therefore, while the CAPM may be useful in designing institutional portfolios, it is less appropriate for the individual and family portfolios that characterize personal financial planning. This conclusion is further reflected in personal financial planning articles that discuss tax efficiency in mutual fund portfolios (Opiela, 2002; Riepe, 2000). Another expression of the relevance of MPT to financial planning is evident in a discussion of issues facing financial planning and of financial planning theory in the Financial Services Review (Black Jr. et al., 2002). The authors of that article claimed that financial planning was well-grounded theoretically, but that research that would guide the application of theory was Volume 7, Issue 1 19 R e s e a r c h & T h e o r y lacking. Modern portfolio theory was cited as the foundational theory, based on a larger view of the decisions concerning consumption and deployment of net worth into assets of all types, not just securities, including the residence, personal possessions and other use assets. Although this theory is plausible and makes theoretical sense, as the authors themselves stated, no empirical research substantiating it appears to be available. Modern portfolio theory is explicitly mentioned in dozens of articles in the Journal of Financial Planning over the past 20 years. Nawrocki (1996) discussed the use of portfolio theory and the limitations imposed by the mathematical Godel’s Theorem of Incompleteness on ever getting to the bottom of a system of mathematics. Nawrocki (1997) later discussed the limitations of the Capital Asset Pricing Model and application by the financial planning practitioner. Despite the fact that there is some concern about applying modern portfolio theory in the form of the CAPM, it is still the main theoretical basis for portfolio management in financial planning. Expanding the theory to include all assets, as suggested by Black, Ciccotello and Skipper (2002), to include use assets and human capital expands MPT beyond its basis in finance into theory and application that is unique to financial planning. Hence, from the existing literature, despite concerns about the predictive nature of MPT and its appropriateness to individuals’ portfolios, modern portfolio theory and the capital asset pricing model can be added to Modigliani’s and Becker’s theories as being foundational theories of financial planning. Educational Topic List of the CFP Board of Standards, Inc., as a Guide for Exploration The educational topic list has changed little over the life of the profession, and probably represents most if not all of the most common financial planning theories. The changes that have taken place consist mostly of additions as the complexity of the tax code, family arrangements, and financial products has increased. The original curriculum at the College for Financial Planning included the following categories of knowledge: Regulation and Ethics, the Financial Planning Process, Risk Management and Insurance, Retirement Planning, Employee Benefits, Investments, Taxation, and Estate Planning (Brandon Jr. & Welch, 2003). There are two more categories in the latest topic list (CFP Board of Standards, 2005), but not much variance over 36 years. An alternative method of organizing and integrating financial planning theory was suggested by Robinson (2000). He states that a good technique for teaching personal finance is to address it from four aspects of neo-classical economics: utility maximization, goal-directed planning, risk management, and the family life cycle, all of which provide a Journal of Personal Finance 20 ©2008, IARFC All rights of reproduction in any form reserved. theoretical framework. He also discussed aspects of personal financial planning that fall outside the four conceptual frameworks. Those aspects appear to be related to behavioral economics and sociological characteristics such as gender, race and culture. Although these conceptual frameworks have merit from a theoretical point of view, particularly when searching for foundational theories, the CFP Board Educational Topics list is used because it has a long history, has been refined by many planners over the years, and is more recognized. As can be seen from the broad nature of the original curriculum and its nine categories and their sub-categories, financial planning is a profession that requires a multi-disciplinary approach. From its original conception it was designed to be an integrative and comprehensive process. This integration was emphasized as a key benefit of the financial planner professional by Dunton (1986) and in early College of Financial Planning study guides (College for Financial Planning, 1986). The nine subject categories gave the structural framework to the remaining exploration of theoretical origins of financial planning. Not every topic within each of the categories was addressed. Selection is based to a certain extent on the frequency with which that topic is discussed in the literature, but also by the admittedly researcher-biased criteria of importance. Financial Planning as Strategic Management: The Financial Planning Process “The financial planning process is the goal and values driven strategic management of the client’s financial resources, a derivative of the strategic planning process that is well known in both the organization and management field and the finance literature” (Overton, 2007). This assertion of origin appears even more likely when an examination is made of the business literature of the time when the financial planning process was conceived. If the financial planning process is a special form of strategic planning and strategic management, then the financial planning process is now theoretically defined. Furthermore, there are more than 50 years of theoretical writings concerning strategy in the organization and management literature that could immediately be used to further refine the financial planning process. As recently as 2005, strategic planning for the family business was the topic of an article in the Journal of Financial Planning (Jaffe, 2005). When the business environment of the late 1960s is examined, when financial planning was founded, it is clear how strategic planning evolved into financial planning. According to Lerner (1999), in the 1960s and 1970s corporate America was “obsessed” with strategic planning. In 1966, for example, the use of strategic planning for small businesses was discussed in the California Management Review (Gilmore, 1966). A version of the strategic planning Volume 7, Issue 1 21 R e s e a r c h & T h e o r y process that is quite similar to the financial planning process appeared in Banking in 1968 (Gibbs, 1968). An article dealing with the problem of strategic plans being ignored by managers was also published in 1968 (Hekimian & Mintzberg). In the same year, an article describing the problems of the strategic planner appeared in Harvard Business Review (Mainer, 1968). Ansoff’s classic Toward a Strategic Theory of the Firm was published in 1969, building on earlier work by Chandler (1962). The interest in strategic planning and its attendant process continued throughout the 1970s. Because of the ubiquitous discussion of strategic planning in business journals and magazines, any group of successful businesspeople in the late 1960s could be presumed to be familiar with the strategic planning process. In April of 1969, some 6 months before the meeting that established the financial planning profession and the CERTIFIED FINANCIAL PLANNERTM certification, the task of the corporate planner was identified as making “a study of the organization’s environment, (opportunities and threats), its resources (strengths and weaknesses), its personal values and its ethical and social responsibility.” (Mason, 1969, p. 109). Note that there was already concern over values, ethics and responsibility, and also note the anthropomorphic transformation of the organization into a person. From an environment permeated by strategic planning, the application of its concepts to personal financial resources would be a seamless transition. Interviews with founders who attended the meeting that founded the Certified Financial PlannerTM certification and the College for Financial Planning have confirmed that fact (Overton, 2007). One of the most important techniques transferred from strategic planning was the environmental scan and analysis of resources, organized into four categories, strengths, weaknesses, opportunities and threats. This “SWOT analysis” is characteristic of the prescriptive design school of strategy (Mintzberg, 1990) and is still explicitly mentioned in two of the more widely used textbooks of financial planning (Dalton et al., 2003; Mittra et al., 2002). One further illustration of the relationship of financial planning to strategic planning is stunningly evident when the steps in the financial planning process (minus the recent addition of establishing the relationship) are compared to the steps in the strategic planning process as stated more than 25 years ago (Bourgeois III, 1980). Table 1 compares the steps of each process. Based on these comparisons, the origin of the financial planning