“What comes next, when you become independent of finance?”
This is a thought experiment was proposed by SavingNinja. The one thing asked of participants is for a stream of consciousness outpouring of thoughts rather than a carefully polished article. Here goes…
Back in my high school days, one afternoon per week was reserved for vocational training.
The principal recognised that while few of his students were destined for tertiary education, a sizeable minority weren’t interested in mastering those subjects that the school was infamous for: applied reproduction, automobile ownership redistribution, or amateur pharmaceutical chemistry.
The school would ask the students to down their calculators, pens, joints, and knives to learn a trade.
Cooking. Motor mechanics. Sewing. Sports coaching. Technical drafting. Woodwork. And typing.
Trying their hand at each for roughly six weeks. Long enough to discern any aptitude or hidden talent.
In most subjects, the teenagers goofed off or played up, as is their wont.
However, in one surprising subject, everyone behaved: typing.
It was taught by a very angry man, with a brutal yet effective approach to education.
Students sat at an old school typewriter, with fingers poised over the keys. A sheet of blank paper was taped to the keyboard, resting over the back of their hands. This ensured the student could not see the keys while they typed. Touch typing is a mechanical skill, muscle memory learned through repetition.
The teacher would write a paragraph on the blackboard, for the students to type out. He would then prowl the room, wielding a metre-long blackboard ruler.
Every typo he spied was greeted with an almighty whack across the back of the offending student’s hands. Always delivered from behind. Always without warning.
To say that students were incentivised to excel would be an understatement! By the end of the six weeks, most students had gained the ability to touch type and developed a lifelong irrational fear of rulers.
When my final typing lesson rolled around, I was a competent touch typist. Figuring that the objective of the class was to learn the skill, I improvised by typing what I wanted to write, the 500 word English essay due by the end of the school day, rather than the set text.
Roughly two-thirds of the way through, I sensed the angry teacher hovering behind me. Fingers flying across the keys, I hammered out the essay’s conclusion. Perfect spelling. Grammar. Punctuation.
“Excellent typing…” said the teacher, stepping away. I breathed a sigh of relief, thinking the threat had passed. I was mistaken. A swift breeze rushed past my ear, immediately followed by a sharp pain across the back of both my hands. Whack! “… but it fails to answer the exam question for this lesson.”
I was reminded of that lesson when I read back over my response to SavingNinja’s thought experiment. Just like an accomplished politician, I had answered the question I wanted to answer, rather than the one being asked. Such is the risk of writing via a stream of consciousness style.
SavingNinja had wanted to know how additional cash flow would be utilised once saving towards early retirement has been abandoned. Given I have never consciously saved towards early retirement, my lived experience is one possible answer. However, that would be a very brief and uninteresting story, so instead my subconscious mind tapped out what follows. Fingers crossed that SavingNinja does not have access to a blackboard ruler or a temper to rival my former typing teacher!
All financial tracking spreadsheets tell a story. Presenting a narrative that supports the creator’s viewpoint. Protecting their ego. Telling a feel-good story that helps them sleep soundly at night.
Choices made. Decisions consciously taken. Assumptions subconsciously baked in.
Our responses skewing the tale that our spreadsheets have to tell. A wise old management accountant once observed that far more lies were told in Excel than Word and PowerPoint combined!
Fundamental questions like what gets included and excluded from your net worth figure?
The value of your home furnishings or car? Sunk costs. Depreciating assets. Few capable of fetching a material sum on the secondary market. Many we would need to pay someone to haul away.
The provisional value of an expected future inheritance? Anticipated, not guaranteed. Amount and timing unknowable, except in hindsight. Yet potentially a life-changing sum of money.
The present value of a future state pension? An annuity by another name, guaranteed by law and underwritten by the government. Except politicians regularly change the rules of the game, making the outcome far from certain.
Endless potential permutations. With no definite right answer, but plenty of wrong ones. The personal part of personal finance.
What does your net worth number get used for? Bragging rights? Stroking your ego? The basis of future income stream projections, as part of retirement planning? Underpinning withdrawal rate calculations?
Issuing these types of challenges quickly focuses the mind. Cutting through the delusions and wishful thinking we may have baked into our spreadsheets. Distinguishing the substance from the noise.
Over the holidays, I invested some time challenging the premises behind my own financial tracking spreadsheet.
Was the narrative it tells still consistent with my current hopes, dreams, and priorities?
Could the assumptions and biases it contained withstand critical assessment and scrutiny?
Did it reflect the financial approach I follow? The learnings discovered as my experience evolved?
Were the questions it answered still the right questions? The questions I wished to answer today?
The results were mixed.
My spreadsheet did a passable job of tracking historical events, a far more reliable basis for anticipating future behaviours than any budget based upon good intentions and wishful thinking.
But it had several shortcomings.
First, it focussed on finances, not life. Money is merely an enabler, not a goal in its own right. Helping pay for those things that are important to us, but unable to provide them directly.
Second, it lacked context. Providing a brief vignette, but lacking the beginning or ending required to tell the whole story. Ignoring externalities that play such a major role in determining the outcome. Inflation. Interest rates. Life expectancy. Market rates. Purchasing power.
Third, many of the charts I had used to illustrate the story failed the “so what?” test. Interesting, but irrelevant. Neither a journal recounting how I got here nor a map leading to my desired destination.
Fourth, it painted a picture that no longer reflected my thinking. When I constructed the spreadsheet, I intended to live off my portfolio’s natural yield. However, in a world of overpriced assets and disappointing yields, I have learned that we should always focus on total returns. Free cash flows pay for the groceries, but real wealth is generated via capital growth!
Fifth, taxes are insanely complicated. Rates vary by asset class. Gains taxed more favourably than investment income, and in some jurisdictions varying by ownership duration. Investment income gets taxed more favourably than earned income. Yet investment income gets added on top of earned income, resulting in it being taxed at our highest marginal rates. My spreadsheet was a miserable failure on the taxation front.
Sixth, it served as a measuring engine but not as a prediction engine. While each chart should tell a distinct story, with a clear message, that is only the beginning. Each should also inform decisions about what happens next? Where is it leading? How might it end? Otherwise, what is their point?
I thought about the forward-looking problems my spreadsheet should be helping me to address.
How much is “enough”?
Are my winter working hibernations still required?
What standard of living can I sustainably afford? Distinguishing between economic inflation and lifestyle inflation.
How do best case, worst case, and most likely scenarios financially play out?
Armed with this newfound insight, I set about reworking my financial tracker spreadsheet.
The way I had chosen to visualise my numbers had painted some incomplete or misleading pictures.
Allocating passive income to offset living costs was a noble goal, but such a presentation only made sense had I first accounted for those investing expenses incurred while generating that income. A more useful measure would be passive income net of expenses.
Comparing dividend or rental income figures over an extended time series using nominal values made me feel good, but doing so told an ego flattering fairy tale. Consider a time series covering seven years, beginning with £100 annual dividend income and concluding with £110. Reading the nominal chart would induce victory dances and self-congratulatory cheers of joy as our figures climbed ever higher. However, the purchasing power of £100 seven years ago might have been 15% higher than £100 buys today. When viewed through a “real” (inflation adjusted) lens, the picture would tell a far different tale. This time it is a horror story, illustrating a relative decline in purchasing power. Bruising to the ego, but more realistic as it reflects how those amounts would feel at the cash register.
Probably the biggest challenge I faced was figuring out how to account for capital growth.
This is unpredictable, as markets go both up and down.
For the most part, capital gains are externally generated. Driven by Mr Market’s often irrational feelings about the future prospects of an asset, company, or the economy as a whole.
Yet capital gains have historically contributed the most growth to my portfolio.
Anyone who adopts a withdrawal rate based strategy for funding their retirement is betting on a certain level of capital growth occurring, on average, throughout their retirement.
Running a simple analysis of my own experience, over 30+ years I’ve averaged a simple annual capital growth rate of nearly 10.5% after inflation.
Which sounded pretty good, until I thought about all the things I once did, but do no longer, to actively manufacture capital growth. As opposed to what I do now, which is to passively sit back and hope.
A 10-year rolling average tells a very different story, my inflation-adjusted capital growth rate is now 5.48%, half what it had been just five years before. This being measured at the height of a bull market, where indices and house prices are said to be at all-time highs!
Looking at gross numbers is great for the ego, but sets the observer up for a lifetime of disappointment when those gains are realised and the tax authorities seek a cut of the proceeds. Making an allowance for an effective tax rate of 30%, this average annual capital growth measure further reduces to around 4%.
So which growth figure should my projections use?
The 10.5% lifetime average?
The 5.5% rolling 10-year average?
The 4% rolling 10-year average net of tax and brokerage fees?
Or none at all, because hope is not a sound basis for a financial plan?
These assumptions matter, because the potential decisions based upon them include whether or not a person believes they can afford to retire. Afford to trade money for happiness by changing roles, stepping down the career ladder, or adopting a part-time working lifestyle. Afford to help out family members in need, becoming a carer for elderly parents or babysitter for young grandchildren.
SavingNinja’s question could have been interpreted in several ways. The author may have conquered their fear of the unknown, and concluded they have acquired a sufficiently large net worth to comfortably coast into a sustainable retirement.
Alternatively, they may have decided it is all too hard, and opted to follow the default life script of working until they reach the point they are too old or their skills too dated for any employer to continue paying for their time.
Ultimately we should each maintain a financial planning spreadsheet to complement our financial tracking spreadsheet. Existing not to provide certainty or fact in the face of an unpredictable future, but to serve as a tool for validating assumptions and exploring options. Providing some measure of comfort that the thinking has been done, and the implications understood.
At which point focussing on the important things, happiness and well-being, rather than financial distractions becomes viable. A wise economics editor recently wrote that “happiness is a side effect of being too busy leading a fulfilling life to think about it“. I think he is onto something, a life independent of finance.
I’m no more inclined to save for early retirement than I ever was, but revisiting and validating my spreadsheet assumptions has proved to be a valuable thought experiment.
To hear some alternative points of view check out the other responses to SavingNinja’s thought experiment:
- Gittins, R. (2021), ‘Prep for the new year: What I’ve learnt about happiness’, Sydney Morning Herald