The internet is overflowing with blogs, magazines, and communities where various minute details of specific topics within the field of personal finance. The abundance of such complicated information, which often requires smaller or larger degrees of contextual knowledge even to be understood, is partly the reason why many subscribe to the false notion that personal finance is complicated.
The Axiom of Personal Finance
Personal finance is not difficult to understand as long as you start learning at the right end, with the fundamentals and basic principles. The intention of this guide is for it to serve as an introduction and a reference for everyone just getting started with building their wealth. When all is said and done, the entire area of personal finance and every single idea and theory for building wealth is founded on a single axiom:
Spend less than you earn, and invest the difference.
You will come across snake oil sellers who peddle get rich quick schemes that contradict the above statement, and naysayers who will tell you that it is simply impossible to build meaningful wealth without taking risks that explicitly goes against this. But Abovare is founded on the above statement, and I refer to this as The Axiom of Personal Finance.
If all you do is internalise the Axiom of Personal Finance and base your financial behaviour on it, you will already be on your way to building wealth. In fact, because we live in a culture that is inherently geared towards consumption and spending, you will find before long that you are better off than the majority of those around you, regardless of your income level.
Based on this axiom, I have created The Abovare Framework for Building Wealth. The framework consists of four basic principles that spring from the axiom, and we can call these The Basic Principles of Personal Finance. By internalising the Axiom of Personal Finance, and practising it through the Basic Principles of Personal Finance, building wealth becomes an inevitability.
The framework and its principles are not a scheme for making money quickly, nor a hidden secret you have stumbled upon by some rare stroke of luck. The truth of why most people are not wealthy is because amassing wealth requires effort and discipline. It takes effort not to succumb to your every buying impulse until this month’s paycheck is gone, and it takes discipline to keep this up each and every month, year after year. Most people are not interested in putting in the necessary effort and developing the necessary control. The masses would rather spend their money mindlessly, while at the same time cursing their luck for not being born into money, not winning the lottery, or not earning enough to be able to save.
By internalizing the Axiom of Personal Finance, and practicing it through the Basic Principles of Personal Finance, building wealth becomes an inevitability.
If you subscribe to similar notions as those mentioned above, scroll back up, and reread The Axiom of Personal Finance. Take it in, and truly absorb its meaning. Do you realise its implications? Do you understand that building wealth will never be about income alone, nor expenses alone, but always about those to parts in conjunction? Do you realise that this means that every single person is capable of building wealth?
Once your honest answer to those questions is yes, you are ready to start building wealth. And The Abovare Framework for Building Wealth was constructed to give you a firm and understandable way to do just that. In fact, I will boldly claim that if you learn the principles expounded on in this guide, everything else you will ever read on personal finance will be recognisable to you as elaborations on the finer points of one or more of these principles.
Principle One: Maintain a Positive Cash Flow
Cash flow is the total sum of money coming in minus money going out over a defined period. If the sum of this equation is negative, it means that the expenses due throughout the period were greater than the sum of incoming money. Or to borrow an apt phrase for this phenomenon from start-up nomenclature: It means that you are burning money.
It is an indisputable fact that no entity, be it a person or business, can survive in the long term with a negative cash flow. The result of a negative cash flow is that you are tapping into your liquid reserves, and at some point, these will dry out, and you will be unable to fulfil your financial obligations. And as such, the priority for anyone looking to build wealth should be to maintain a positive cash flow.
While you can calculate your cash flow for any given period, it is commonly measured on a month to month basis. Some people prefer to calculate cash flow based on when they are paid, for instance from the 15th of one month to the 15th of the following month, while others calculate it for each calendar month. Whichever way you choose to do it is of little significance, so long as you keep track of your cash flow.
Tracking and Evaluating Your Cash Flow
Tracking and measuring your cash flow is as easy in principle as it sounds. If your bank account balance is larger at the end of the period than it was at the start of the period, your cash flow is positive. And your net cash flow is the end balance minus the opening balance. With cash flow being such an all-important measure of personal finance, I cannot stress enough the importance of everyone to be both tracking and recording their cash flows on a monthly basis. Many banks will already offer services for this, and furthermore, there are many online tools for this such as YNAB and Mint that will let you aggregate data from several sources. Personally, I prefer to use an old-fashioned Excel spreadsheet.
Of course, tracking your cash flow means little unless you also take the time to evaluate the various factors that influence it throughout a given period. While not strictly a necessity, setting up a budget can be an invaluable tool when it comes to keeping up with your cash flow, and is highly recommended for two reasons:
- An estimate of free cash flow: A budget will include all your fixed expenses. These are the minimum expenses you will incur just to maintain your desired standard of living, and includes things such as rent or costs of owning a home, food, utilities and so forth. With all fixed expenses accounted for, what remains is your free cash flow, and you can divert it towards increasing your liquidity, investing or discretionary spending.
- It serves as a reference point: With your budget in place, you will be better equipped to understand which variables affected your monthly cash flow. It will be easy to see that your fixed expenses had a sudden increase, and you will immediately realise that this, in turn, means that you must reduce your discretionary spending to keep your cash flow at the target level.
It is important to note that a budget is not the truth, but merely your expectations for the future. However, by constantly evaluating your actual cash flow against your budget, you will be able to refine your budget, and at the same time increase your understanding of your finances. Budgeting is a broad topic, and you can learn more about it by reading the posts in the budgeting category.
Cash Flow Reliability
An often forgotten, yet important component of personal cash flow assessment is assessing the reliability of your cash flow. For most people, this is analogous to evaluating their job security, and this is a fact not to be taken lightly in what seems to be a society in which steady employment simply cannot be taken for granted. It is, therefore, imperative to take measures to improve the reliability of your cash flow.
For many looking to get started on the path to building wealth, this is a shift in mindset that is hard to enforce. It is so ingrained in our culture that our employer is the source of all our inflowing money, and if the company severs the agreement, our only option is to start looking for another job. For someone looking to build wealth, and increase their freedom, this is simply a too inhibiting mindset.
It is so ingrained in our culture that our employer is the source of all our inflowing money, and should that connection be severed, our only option is to start looking for another employer.
Increasing the security and reliability of your cash flow then means diversifying the sources from which it originates. One way of doing this is to take on a second job, as it follows logically that this is more secure than relying on a single job for income. A more efficient way of increasing cash flow reliability, however, is to make your money work for you. In other words, your money should be making money for you, and this is the concept of investing.
When you start investing, cash flow size and reliability ceases to be only a function of your labour and instead becomes a function of the amount of money put to work, and the risk you are willing to take on. This concept is the primary reason why you should be actively looking to build wealth. When invested, capital generates cash flow, and in turn, lessens your dependence on providing labour in return for money. As work equals time, reducing your dependency of working increases your freedom to manage as you see fit the only truly scarce resource in your life: Time.
Investing is on its own a discipline which thousands and thousands of people dedicate their lives trying to understand and conquer, and not the main subject of this article. For now, it will suffice to know that you should be actively trying to diversify the sources of your cash flow and that in time, as you continue to build your wealth, investing will become one of those sources. Because, contrary to popular belief, it is not hard to construct an investment strategy that is profitable in the long run. To learn more about investing, you can take a look at the posts in the investing category.
Maximise Your Free Cash Flow
The key takeaway from this should be that you should be actively monitoring your cash flow and increasing its reliability by diversifying its sources. But even more importantly, for as long as you are building your wealth you should always be looking to maximise your free cash flow. This because your free cash flow is the upper limit of what you can dedicate towards increasing your wealth. Additionally, the larger your free cash flow is, the better equipped you are to handle unexpected expenses without dipping into your liquidity reserves and investments.
As a general rule of thumb, however, you should at the very least aim to ensure that you tie no more than 70-80% of your monthly income to fixed expenses.
Increasing your free cash flow is, of course, when you get down to it, a simple function of two components: Your cash inflow and your fixed expenses. The larger the difference, the more money you will have available to put to work for you. By now it is natural to be seeking an answer to the question “How big should my free cash flow be?” The long and short of it, however, is that there is no firm answer to this. It depends on several factors, such as your income, your goals, and your overall life situation. As a general rule of thumb, however, you should at the very least aim to ensure that you tie no more than 70-80% of your monthly income to fixed expenses.
A note on budgeting and methodology: Many people, myself included, practice what is called zero-sum budgeting. It is important to point out that making a plan for every penny of your income does mean that your free cash flow is zero. To calculate your actual free cash flow while practising this methodology for budgeting, you have to separate actual fixed costs that you incur each month from optional budget items, such as for instance saving, investing and discretionary spending.
Principle Two: Manage Your Liquidity
With your cash flow under control, you are now generating excess cash every month, and it is time to consider how to utilise this extra money effectively. One option mentioned previously is to put the surplus money to use and invest it. Doing this without first constructing a strategy is not only foolish, but it can indeed become costly.
The word liquidity has slightly varying meanings, depending on whether the word applies to an asset or a person. With regards to assets, how liquid it is will be defined by how quickly said asset could be bought or sold without affecting the price. A house will typically be a highly illiquid asset whereas stocks in a publicly traded company will be liquid by comparison. For a person, liquidity is a measure for how quickly one can meet her financial obligations. Or, in more simple terms, your liquidity from a personal perspective is simply a measure of how much cash you have on hand, as cash is the de facto standard for liquidity.
… in more simple terms, your liquidity from a personal perspective is simply a measure of how much cash you have on hand
So why is liquidity significant from a personal finance perspective? For one, it is important to prepare for the unexpected. Even the best of budgets can fail to account for irregular expenses, be it the deductible of an unexpected hospital visit, or car repairs following an accident. If these costs exceed your free cash flow during a given period, it means that unless you have the sufficient liquidity to cover them, you have to either sell off investments or take on debt. Likewise, should your cash flow take a nose dive because you lose your job, or you are unable to find a new tenant for your rental property, keeping enough cash available ensures that you can cope without resorting to the measures as mentioned earlier.
Additionally, sufficient liquidity also means that you can take advantage of potentially lucrative investment opportunities that would otherwise be out of bounds, or not as desirable with other, more costly methods of financing. Consider a relative selling the house, and being willing to let it go for a discounted price in exchange for a quick sale. If you have the necessary liquidity on hand to get a loan at a desirable rate, this could be a good deal that you would not be able to finance without the cash in the bank.
The Risk and Reward Relationship
At this point, it is reasonable to assume that keeping all your assets in cash sounds like an attractive strategy, as it is the most secure way of making sure that you can meet all your financial obligations. Unfortunately, such a tactic comes with a cost. Remember how we concluded that the primary reason for building wealth is to make money by putting your money to work, so that you, in turn, can enjoy the increased freedom that comes from this source of income? Cash, in the long run, is the asset class with the lowest expected returns. The price of keeping cash on hand, then, are the returns you forgo by not investing that money in other asset classes.
The underlying mechanism that makes money less profitable than other asset classes is a staple of our entire financial system: In a functional market, increased risk equals increased expected returns. By keeping money in hard cash, there is absolutely no risk whatsoever, from a financial point of view, that you will lose your money. But those beautiful hundred dollar bills are also generating absolutely no returns, and over time, in a functioning economy, the money will slowly lose its value if you account for inflation, which is the price increase of goods and services.
If you put the same amount of money in the bank, there is still close to no financial risk, and your money will be there and available for you to use. The bank, however, will pay you a small amount for “lending” them your money, by awarding interest on the deposited money. Historically, cash deposit interest will roughly trail inflation by a small fraction, which means that even by keeping your money in the bank, you are still losing some of its purchasing power over time. The upshot, of course, is that it is there and available for you to spend at any and all times.
The alternative to keeping cash is, as previously noted, investing it. Let me first point out that we are in this context not referring to the colloquial meaning the word has taken on over the past couple of decades. Contrary to popular belief, you do not “invest” in a new pair of sneakers or the most recent iPhone model. Investing, from a financial perspective, is the act of committing money with the expectation of profiting or gaining additional income. We live in a world filled with different investment opportunities, both good and bad. Examples are purchasing a house, with the belief that it will appreciate in value, or buying shares of stock in a big company, expecting that it will create shareholder value in the form of dividend payouts and increased stock prices. In the name of making things easier to understand, let us narrow the definition of “investing” to buying equity in the financial markets when illustrating the relationship between risk and reward.
We now know that cash is low risk, but low yielding asset class. Buying shares of stock, or equity, in a company, is another asset class, which has the bonus of higher expected returns than cash in the bank. But, as you well know if you have ever read a paper, stocks are risky business. It is nigh on impossible to watch the news without someone popping up to tell you that company x or y, or worse yet, the entire market is going to tank. In other words, shares of stock can both increase and decrease in value, and dividends are typically only paid out to shareholders in years with good financial results. The reward for this potential volatility is higher expected returns compared to keeping your money in the bank.
A way of mitigating the risk of a single company performing badly, losing its value, and not paying out dividends, is to spread our investments across several companies. In fact, with a properly diversified portfolio of investments, it is possible to rid yourself of all the risk that is tied to a particular company, because the positive performance of the stars in your portfolio will negate the negative performance of others. If this sounds familiar, it is because this is the same principle of diversification you should use to increase the reliability of your cash flow.
When using diversification to remove all company specific risk, what remains is the systematic risk. That is the risk of the market as a whole going down. This chances of this happening are, of course, a very real at any time. But, while nobody can predict the future, history has shown that the general trend of the market is up. And, remember, you assume this risk because it comes with a potentially much greater reward than keeping your money in the bank, where it is only yielding the risk-free rate of return.
The next question you should be asking is how much extra money you will make by investing in the market compared to the bank. The only actual answer to this is, and will always be, nobody knows. The future is always unknown. What we can do, however, is look at the past for some clues of what to expect. Below is a graph that shows you how much money you would have at the end of 2015 if you in 1981 put $1,000 in the bank (blue line) compared to investing $1000 in the S&P 500 (red line) in the same year. The S&P 500 is a stock index that comprises 500 large companies listed on the New York Stock Exchange (NYSE) or NASDAQ and is a decent approximation of the entire American stock market.
Chart note: Data sources are The World Bank for US lending rates, and Money Chimp for Compound Annual Growth Rate of the S&P 500 with dividends reinvested.
Before examining the results here, note that the red line is based on historical lending rates. Bank deposit rates and subsequently accumulated returns, throughout the period would likely have been significantly lower. But the overall point remains unaffected because even with these generous rates the cumulative return from the S&P 500 over the 34 year period eclipses the interest rate returns. $1,000 placed in in the S&P 500 at the start of 1981 would have been worth a whopping $38,684 at the end of 2015, while the same amount sitting in a bank account throughout the entire period would only have increased to $11,145.
The keen eye will notice that it is not all roses in the market, however. There are several periods where the value of our investment decreases! Especially noticeable are the dips in the years 2000 and 2008. That is the systematic risk of a market downturn kicking in, and you are most likely more than familiar with those occurrences already: The dot-com bubble of 2000, and the 2008 financial crisis. All the while our bank deposit kept on increasing, slowly, but steadily.
An important takeaway from this should be that, even if our investment portfolio lost nearly half of its value from 1999 to 2002, and then took another big hit in 2008, it remained almost twice as valuable at its worst compared to our stash of cash. These points illustrate the importance of time in the market. By keeping your assets over long periods of time, the expected increased returns will compound, and reduce your vulnerability to corrections and short term fluctuations.
Ideally, it would be great if we could time the markets, and pull our money out of the markets as the values peak, and then reinvest as the market values are at their lowest before the trend reverses again. Not only would we avoid the dips, but we would be able to take advantage of the still positive bank rates while the market value plunges! I hate to be the bearer of bad news, but this is impossible. There is simply no reliable way of timing the market, just as there is no reliable way of telling the future. Understand that these two things are one and the same. If anyone ever claims to you that they can reliably predict the markets, say to them that you would like to invest on their advice by borrowing money from them, and pay them back, with generous interests, with the returns you will be earning. When they refuse, you know that they are lying as they are not willing to bet on their own advice. And, more importantly, because money should quite simply be of no concern for someone with the ability to reliably time the market.
Define Your Minimum Liquidity Threshold
At this point, you should have a firm grasp of the pros and cons of holding cash versus investing in the market, and that maintaining your liquidity is important for two separate reasons:
- Obligations and Opportunities: Having sufficient cash ensures that you can meet your financial commitments, and affords you the option of taking advantage of investing opportunities that may come your way.
- Mitigating risk: Cash (or assets with cash equivalent properties) is an essential part of any well-constructed portfolio of assets because it is virtually risk-free, and thus mitigates the risk of loss.
Point number one is fairly intuitive, and while there is no firm answer to how much cash you should keep based on obligations and opportunities, you should be able to set your target with some consideration. Commonly, the target is anywhere between and three months to a full year’s worth of fixed expenses, but at the end of the day, you must set your goal by assessing your personal situation. Variables to account for when defining a target here include cash flow reliability, the likelihood of future expenses that exceed free cash flow, and whether or not you see any potential future investments you want to finance.
The target set based on the first point above should serve as your minimum liquidity threshold. Before you reach this goal, and if your liquidity falls below this magic number, you should not be investing money, but instead, focus on building your stash of cash. Access to pre-tax investing and potential employer matching, which is common in the United States, complicates this discussion somewhat. Discussing this at length is beyond the scope of this introduction. But if you have this opportunity it is advisable that you make an informed decision on whether or not to it is beneficial to take advantage of it (it almost always is) and treat the above rule of thumb as applicable to after-tax cash flow judgment.
Once you have amassed enough liquidity as defined by your goal based on obligations and opportunity, the second point of consideration becomes applicable. From here on and out, you need to balance your investing and cash accumulation based on your willingness to assume risk. Because, as discussed in the previous section, investing for higher returns always comes with the cost of increased risk of loss. Discovering your tolerance for risk is a continuous process of assessing and reassessing. Factors that influence your tolerance will change along the way, and it is important to be aware of this to maintain a conscious relationship to your risk tolerance.
Age tends to be one of the most important factors when determining risk tolerance. While the stereotypical boldness of youth as a psychological phenomenon certainly plays a part in explaining why, there is also a more rational aspect to this, and it is one we have already touched upon: Time in the market matters. Someone who is young and accumulating wealth may not be looking to withdraw from their assets until several decades into the future. The result is reduced vulnerability to short-term variation and corrections and gives them more time to reap the compounded gains of a market that will presumably be growing over time. Additionally, young people tend to have less responsibility and fewer dependents, be more adaptable and are more likely of seeing significant future increases in disposable income.
These age differences are why young people are typically advised to opt for a more risky asset allocation than older individuals who find themselves closer to retirement age. Risk tolerance, however, is measured on a spectrum where it is difficult, and dangerous, to make general assumptions. The only person who can make an informed decision about what you should be willing to risk is yourself. I can tell you that, even knowing that the past is not a reliable indicator of future, I believe the economy will continue to grow in the future. Because of this, I am willing to assume an amount of risk in return for higher expected returns and place a portion of my wealth in the financial market. What I cannot do is promise you that this will be the case. I do not know the future, nor do anyone else. Therefore, it is up to you to decide whether you are to make the same calculated bet and to which degree.
At the end of the day, a general rule of thumb that is usual to keep in mind when defining your tolerance for risk is that you should only invest what you can afford to lose without it irreversibly ruining your personal finances. What is irreversible ruin, then? Well, that is up for you to decide. Some cannot stomach the thought of losing a single dime of their hard earned dollars, and those people should stick to risk-free assets. Nobody can condemn such a choice, even if it is, from a rational financial perspective, unwise because it involves leaving potential upside on the table.
What Is The Actual Risk?
Up until this point, we have been discussing risk in a very general sense. It is important to contemplate what risk is, the relationship between risk and expected returns, as well as your willingness to assume risk in exchange for potential gains. Previously we defined that when talking about investing and risk, in general, we are doing it in the context of the financial markets. We have also looked at the development of the American market as represented by the S&P 500 in the period from 1981 to 2015. In the scheme of things, this is a relatively short timespan. So let us instead take a look at how the S&P 500 did throughout the entire period with available data, from 1871 to 2015. From this, we can get an indication of the actual risk of investing in the market.
Chart note: Data source is Money Chimp for Nominal and Real Compound Annual Growth Rate of the S&P 500 with dividends reinvested.
The exponential increase in value caused by compounding returns over such an extended period makes it difficult to gain much information regarding risk. What is worth noting, however, is the difference between the nominal value of your investment, and the inflation-adjusted value, commonly referred to as the real value. While the hypothetical $1 invested in tracking the S&P 500 in 1871 would be worth a whopping $258,000, the real value is a meagre $15,000 as a result of inflation. As noted earlier, inflation is a measure of the general price increase of goods and services over a period.
The result of inflation is that a dollar will purchase less of a good or a service than it did when you invested it. It, therefore, makes sense to evaluate the performance of your investments based on inflation-adjusted returns, because this is an accurate indicator of how much the return on your investment has increased your purchasing power.
Circling back to risk, a better way of assessing the risk involved with investing, based on this time frame used in the chart above, is to look at the different outcomes based on when you invested and your holding period. From this, we can understand more about how timing and time in the market influence our returns.
Chart note: Data source is Money Chimp for Inflation Adjusted Compound Annual Growth Rate of the S&P 500 with dividends reinvested.
This chart is showing returns based on the number of years an investment is held. Each little double circle represents an investment bought at a particular January 1st between 1871 and 2015. Its placement on the horizontal axis determines when this investment was subsequently sold (years held), while how high up it is on the vertical axis shows the return it yielded. One example is an investment made on January 1st, 2015 and sold on December 31st the same year. This dot will be found in the first green cluster from the left and is placed right on the fat grey line because it yielded no return. The highest performance in a single year holding period, found in the first green cluster from the left, was 1954, which increased your return with almost 60%. You see this represented by the highest placed green dot in the one year held cluster, with a multiplier value of 1,57.
Looking at the ten years held-group, you can see that vast majority of green dots are well above the highlighted grey line that indicates our initial investment, which shows that your investment has increased in real value, as all of these data points have are inflation-adjusted. However, out of the 136 different 10-year holding periods, 15 of them, or around 11%, yielded real losses.
If you were unlucky enough to invest in an index fund that tracked the S&P 500 at the beginning of the year 2000, and sold it ten years later, at the end of 2009, your investment would have lost 30 % of its value. But, if you had held on to that investment for six more years until the end of 2015, the value would have been 2,6 times what you initially invested.
The perhaps most important takeaway from the data portrayed by the chart is that the amount of time you hold an investment both increases the average return and decreases the likelihood of losses, which resonates with the importance of time in the market. For instance, while a one-year holding period only has an average return multiplier of 1,08, and 31% of the observed outcomes are negative yields, a 20-year holding period has an average return multiplier of 8,32, and no observed outcomes with negative yields.
Even after examining these historical trends, and extrapolating future assumptions based on them, the most important factor in determining how much you should invest should be your personal risk tolerance. While the data clearly shows that in the past nearly any holding period over ten years would yield positive returns that exceed regular bank deposit rates, the fact of the matter is that the past is not a reliable indicator of the future. This data set is also solely focused on the US market, and the US has experienced unprecedented economic growth throughout the period. Limited economic growth will mean limited returns, and periods of decreased market values are an inevitability in any and all economies.
Make Your Choice and Live With It
To summarise, the second principle of our framework for building wealth is about defining your need for liquidity, and the various factors you should consider when deciding on how to allocate the excess cash once you reach your minimum liquidity threshold. Investing in equity in the financial market was presented as an alternative to holding cash.
It is important to have enough control over your cash flow, expenses, and liquidity reserves when you start investing that you are not forced to liquidate your investments to cover your liabilities. The reason for this is, as we have now discussed and seen backed up by data, time in market matters. Additionally, investing and liquidating incurs costs, and minimising these costs is important to keep them from impacting your returns. Even seemingly insignificant costs can have a severe impact on the long term, compounded returns.
While at the end of the day nobody but yourself can make an informed decision about how you should allocate excess cash, taking advantage of investment opportunities that generate returns above the risk-free rate of return is imperative for those looking to build wealth and increase their freedom. My advice is that you make a thorough evaluation to define a minimum liquidity threshold that makes you comfortable and sleep well at night, and once you reach that goal, start diverting a significant portion of your free cash flow towards investing.
Principle three: Focus on Profits
At this point in the process, many will take interject that they are already monitoring they incoming and outgoings every month, and are in full control of their profits by keeping tabs on how much is left over each month. And that is an understandable reaction because intuitively it makes sense that your profits equal the amount surplus money you have left each month. But this is the step where we stop thinking about money as something that just comes in and goes out in certain set amounts. Instead, we start taking responsibility for what our money is doing to increase our freedom.
Positive Cash Flow Does Not Equal Profits
First, let us start by examining the difference between cash flow and profits and losses, and the best way of doing it is by using an example. Say you want to buy a new, fancy car. You go to the dealer and get what you believe to be a decent offer at $20,000, and you decide to buy it. Given you have a lot of cash in your bank account, you opt against financing the car and instead pay it in full. What did the car cost you?
If you just thought to yourself that the car cost you $20,000, congratulations, you just took the first step to learning something new. $20,000 was not the actual cost of the car; it was your net cash outlay. In other words, your cash flow statement the month you bought the car will take a $20,000 hit. The cost of the car, however, is $20,000 minus whatever sum someone would be willing to pay you for the car. The correct answer is, in fact, that the car cost you $20,000 minus whatever sum someone would be prepared to pay to buy the vehicle from you.
Consider the unlikely event that after buying the car, you discover that it was real collector’s item and that your good friend, the car collector, tells you that he would be willing to take it off your hands for $50,000. But, you like the car and want to hold on to it, so you decide to keep it despite his offer. What did the car cost you? Remember the equation above. The car cost you the $20,000 you paid for it, minus whatever someone would be willing to pay you for it. Solving that for the $50,000 your friend wants to pay for the car, we get the tidy sum of -$30,000. Alright, so what does this mean, a negative cost? Well, a negative cost is, as I am sure you understand by now, profit.
Now keep in mind that because you opted to keep the car, your cash flow for the month is still $20,000 down, even after you discovered that, as it stands, you’ve made a profit of $30,000 on the car. Your cash flow will only be impacted the moment you decide to realise your investment, or in this case, to sell the vehicle. In other words, your cash flow does not equal your profits. Before I proceed to illustrate how this affects your finances in a more practical matter, I feel obligated to note that cars, as a general rule of thumb, make terrible investment vehicles (pun intended) and should nearly always be treated as a depreciating asset.
Introducing the Concept of Book Value
When you make an investment, providing you pay for it outright, you negatively impact your cash flow, but your overall wealth does not change as the transaction does not yield a profit or loss. An important caveat here is the fact that most transactions incur a transactional cost, which we will be ignoring in this case for the sake of simplicity.
The conclusion to this line of reasoning, then, is that profits, or losses, are not a result of how much excess cash you can generate over a period. Your profit or loss over a period can instead be expressed as the change in the number that is calculated by adding up the value of all your assets and then subtracting all your liabilities. Those well versed in personal finance already will immediately recognise that this is the same as saying that your profit or loss is the change in your net worth.
Your profit or loss over a period of time can instead be expressed as the change in the number that is calculated by adding up the value of all your assets and then subtracting all your liabilities.
Put another way; it does not matter if you can generate a positive cash flow every month, but keep sinking your excess cash into terrible investments that depreciate over time. To focus on profits, then, is to monitor your investments and make sure that they are developing in a way that increases your wealth.
An important aspect of evaluating your investments, and making sure you are turning a profit, is the book value of the asset you are examining. The book value is the amount of money we deem an asset to be worth on our balance sheet and is a critical number when it comes to determining the performance of our investments, as well as our net worth. In financial accounting, many rules govern how a business should calculate the book value of its assets. When it comes to personal finance, there are no guidelines, and the way one person does it might differ from the next.
The degree to which we can confidently and accurately determine the book value of an asset correlates with the liquidity of an asset. A liquid financial asset, such as a publicly traded company listed on a large stock exchange will be bought and sold each and every day, and as a result, you can quickly and accurately determine the value you should give the asset on your balance sheet by looking at the stock price. A home, on the other hand, is not as liquid, and you will never get a perfect valuation from the sale of an identical asset, the way you will with stocks. As such we need to make approximations based on factors such as the general trend of the market and the sale prices of similar objects in the same market.
When it comes to estimating the book value of less liquid assets for measuring the profit of your personal finances, there are no rules. However, the following rule of thumb can be helpful to keep in mind as a general guideline: The book value should be the highest value you can say with reasonable certainty the asset would fetch if you were to sell it. In other words, you want to be as accurate as possible with a cautious approach.
Asset Classes and Profits
Typically, an investor will be considering five different classes of assets when constructing a portfolio in the search for earnings. These five classes are:
- Real estate
There are obviously other financial instruments and classes of investments not covered by this list, but for most investors learning about, and investing within these five classes will be more than sufficient to establish a robust portfolio. We have already covered the value of keeping enough cash, and the same arguments apply to why it is a critical component of every well-constructed portfolio. But, with your liquidity threshold covered, in which other asset class should you invest? Which of them will yield the most profits, and thus increase your wealth and freedom?
Unfortunately, there are no firm answers to this question. What we do know, however, is that the various asset classes have differing strengths and weaknesses with regards to factors such as expected long-term returns, volatility, and how their values are affected by macroeconomic changes. As such, every investor should familiarise her- or himself with all of the five asset classes listed above, and aim to diversify their investments across all classes to maximise the relationship between expected returns versus downside risk. You can go to the investing category to find all posts about investing, to read more about the subject.
What to do when Losing Money?
We now know the importance of tracking your profits. How often you should be doing it depends on whether you have an active or more passive approach to investing, but regardless of this you should be tracking how your investments are doing at regular intervals. But, shock and horror, during one of your regular checks of the health of your investments, you discover that certain assets are losing you money. How should you react?
The first thing you should be doing is to concentrate on not panicking. Every investor loses money at some point, and during downturns, the losses can often be significant compared to the overall value of your portfolio. Loss handling is, therefore, an essential skill for every investor. Instead of selling off all your assets in a downturn, the right reaction to a decline is to have a holistic evaluation of the underperforming asset and try to uncover why the asset is decreasing in value, and whether this calls for action.
- Have the fundamental properties of the asset that made you believe and invest in it changed? If yes, the time might be right for you to get out. If not, stay true to the course. Market overreactions are common, in large part because of short-term investors reacting to short term signals. Do not let these dictate your long-term strategies and beliefs.
- Is this a market downturn, rather than an asset decline? Market risk is real, and you should already be countering it with diversification. Therefore you should never base your investment decisions with regards to specific assets based on market swings caused macroeconomic variations.
- Are the changes significant enough to warrant a reallocation? An investor will typically define an appropriate allocation of his or her portfolio between the various asset classes. If one particular type of asset decreases in value, this will be a signal to buy more of that particular asset class. Be sure to keep an eye on your asset allocation, especially in downturns.
Evaluate Short-Term Performance and Focus on Long Term Profits
We can summarise this section by saying that while profits are indeed important, they are not the be all, end all in the short term. What is truly important is to monitor the performance of your assets regularly, and evaluate the short-term performance in a composed and rational matter. Once you have defined your investment strategy, it is essential to stay true to it and avoid overreactions by changing things up because of short-term changes unless the strategy dictates it.
Principle Four: Monitor Your Net Worth
The final step in this introduction to managing your personal finances is to track your net worth. Many people will only look at the amount of cash in their bank accounts and make a judgement call on their financial well-being based on the number that flashes on the screen. Having read through this guide, you are now acutely aware of the fact that there is more to your financial health than just cash in the bank. All of those investments that are generating returns, and this way contributing to increasing our wealth and freedom, are part of the picture.
By including the full picture of all our assets and liabilities, not just cash, we get a complete overview of our financial well being. This number is as easy to calculate as you would intuitively believe: Simply take the summarised value of all your assets, and subtract your liabilities, and the result you end up with is your net worth.
The Most Important Number
Your net worth is, in the grand scheme, the most crucial of all the numbers related to your personal finances. Yes, making sure you can cover all your expenses by keeping enough cash on hand is important. And yes, your income says something about your potential to build wealth. But in the long run, if you are not increasing your net worth, you are doing something wrong. Your net worth is your wealth, and, within the framework that I outlined throughout this guide, you should consider every money decision in the light of how it affects your net worth.
Every pound, dollar or euro increase to your net worth equals incremental progress of your freedom in life. And by focusing on this number, it is possible for everyone to increase their net worth to the point of having enough freedom to not having to worry about how to pay your rent. Or how to afford health insurance. Or how to save the money for a down payment on a home. Or the fear of a period of unemployment.
And the great part, which should be one of the most important takeaways from this article, is that thanks to the magic of time and compounding, a steady focus on improving net worth today means that tomorrow’s improvement will be even more significant. That is all down to the fact that you are smart enough to put your money to work for you.
If you have any questions or suggestions regarding this article, do not hesitate to get in touch.