“The fastest vehicle in the world is a rental car with no insurance excess.”
This line from an old Top Gear rerun brought a wry smile to my face. My kids were avidly watching the three hosts racing the length of what may have been New Zealand, pitting a crappy budget rental car against a racing yacht piloted by a very young looking Ben Ainslie.
While not strictly true, the sentiment struck a chord with me. There is a liberating freedom associated with enjoying the usage of something, while avoiding the accountability of ownership.
Rental cars that magically transform into racing cars, rally cars, or off-roading machines in a manner for which they were never designed.
Hotel guests who happily trampoline like young children on the beds, and enjoy a hot shower with a duration measured in hours (without sparing a thought for the resulting utility bill).
Tenants who observe, then choose to ignore, maintenance issues. They don’t want the hassle. The clean-up. The wait for tradesmen who never turn up.
The lies we tell
Recently a reader commented that:
“People lie. Numbers don’t”
Initially I chuckled at the apparent naïvety of the statement.
My personal experiences as an accountant and working at an investment bank had confirmed many times over the quote:
“more fiction is written in Excel than Word and Powerpoint combined!”
Then I thought about it some more.
- Choosing what to measure is a choice made by people.
- Selecting the method of measurement is a decision.
- Determining how those figures will be analysed is a judgement.
- The interpretation of the numbers involves perspective.
- Making a decision based on that interpretation is an act.
All these activities are performed by a fallible person; subject to the same lapses in judgement, gaps in knowledge, biases and wishful thinking that we all suffer from to varying degrees.
The numbers themselves just are. Objects, like rocks. It is the perspective of the beholder that decides one rock is a worthless piece of shale, while another is a priceless diamond.
Therefore upon reflection, I must humbly apologise to that reader for doubting them, and applaud the wisdom of their perspective.
A person’s propensity to delude themselves is boundless indeed!
Year end rituals
With the holiday season approaching, it is a common practice to benchmark your financial performance over the calendar year.
This time of year presents an opportunity to pause, reflect, evaluate, and… shirk accountability!
Some people will perform a victory dance in celebration of their numbers improving, proclaiming their financial genius, while channelling their inner politician by claiming full credit for the outcome.
Never mind about externalities such as Brexit pounding the Pound, creating a very flattering view of how performant a (wisely) internationally diversified portfolio may actually have been.
Others will throw a tantrum at their numbers declining. All too often this is followed by seeking to shift blame:
- The Fed upset the market gods.
- Trump’s tariffs, trade wars, and conspiracy theories.
- Brexit uncertainty, the UK government’s unprecedented levels of acceptable incompetence.
- Raising the migration drawbridge scaring away all the foreign buyers, who have kept the London property market propped up for the last several years.
The problem with blame shifting is that the individual passes up the opportunity to learn from the experience and avoid repeating the same mistakes.
So this year why not try a different approach?
Instead of trying to force your numbers into a narrative you want to believe (the “People lie” part), why not genuinely try to hear the story your numbers have to tell (the “Numbers don’t” part)?
Net worth can be defined as what you own less what you owe.
The goal of this metric is to quantify exactly how much you are worth. Sounds simple, right?
Consider some of the following key questions.
What valuations do you apply to those assets where there isn’t a clear current market price?
Do you use an estimate? Your own, or one produced by a third party such as a real estate portal or used car price guide?
Do you select comparable recent sales prices? If so, how timely are those figures?
Is the valuation you use for your net worth calculation the same as you use for the purposes of insurance coverage? If not, then why not… they can’t both be right?
Do you include accumulated equity in your home?
You could sell your home, so it is definitely an asset, even if it isn’t much of an investment.
You could extract equity by refinancing.
You could take advantage of geographic arbitrage and move somewhere cheaper.
Goods and chattels
How about rapidly depreciation assets, such as your vehicles and home furnishings?
Your insurance policy may offer a “new for old” replacement facility. However that doesn’t mean your goods are still worth what you paid for them.
For larger items there is probably a secondary market price those items would fetch, in all likelihood this will be much lower than you imagine it to be!
When viewed from this disposal value perspective, the vast majority of your stuff is actually worthless… possible less than worthless, in that you may actually have to pay for someone to take them away.
Do the balances you are carrying factoring in the fees, taxes and charges you would incur upon disposal your assets?
On paper an investment property or shareholding may be sitting on lovely capital gain.
Realising that gain may incur brokerage, conveyancing, or financial settlement charges.
The tax man may also syphon off a material portion of the sales proceeds in capital gains taxes.
Ignoring these costs won’t make them go away, but may provide an inflated view of what you are actually worth.
Does your calculation include the value of your business interests? If so how realistic are those figures?
A business may carry intangible assets such as goodwill on its balance sheet. Examples include the value of its prominent brand, reputation, and impressive list of established customers.
Were that business to be liquidated, those intangible assets would likely prove difficult to turn into cash, a similar story to your household possessions discussed above.
Provisions for future events
Does your net worth account for incurred or foreseeable changes?
You may have incurred, but not yet paid, a significant tax bill. From an accounting perspective this would be classified as a liability.
You may have been awarded, but not yet received, a major performance bonus or sales commission. Accountants would recognise this as an asset.
As you can see there is a great deal of judgement and subjectivity underlying a simple net worth calculation. What works for you is likely to differ for the next person. Without first reconciling the methods use, any form of comparison between your net worth and somebody else’s is meaningless.
We all have a tendency to optimistically value our assets, ignore disposal costs, and inflate our realistic net worths.
This is human nature. It is also an example of people lying to themselves.
However fanciful or accurate your net worth number may be, it serves as a milestone along your financial journey.
A common evaluation involves comparing your current year-end net worth to the previous year. Did you win or lose?
Let’s pause for a moment and consider what is actually occurring.
- You are observing account balances and investment prices on an arbitrary date.
- You are comparing those figures against balances and prices on another arbitrary date.
- Those arbitrary dates are separated by an arbitrary interval, in this case a calendar year.
Providing the rules and definitions applied are consistent there is value in this comparison ritual, as it allows you to evaluate in aggregate how you have performed compared to the previous year.
Analysing net worth
However the real value is digging into that net worth number to analyse and understand what is actually going on.
Consider the following questions:
- What is the breakdown in contribution to your net worth between investing wisely and excess cash flow? A rising market can mask a multitude of ills.
- How have the proportions of what you own and what you owe changed? Are you more or less leveraged than last year?
- Evaluate your asset allocations. Are they materially different to last year? Are they aligned to your target allocations?
- Determine how much of your net worth is accessible today? Locked away until stock options vest, or your fixed term private equity investment expires? Age restricted due to pension rules?
You may realise that you are asset rich, yet cash poor. All your wealth may be tied up in your home or a pension you can’t touch for another 30 years.
You may learn that between your personal investments and your pension, your exposure to your home market and currency is much higher than you appreciated.
Thinking about how the tax man will pick your pocket when you sell an asset may let some of the air out of your tyres, providing a more realistic perspective on how of your net worth is actually yours!
A savings rate can be defined as the proportion of what you earned that you actually kept.
The goal of this metric is to monitor the difference between your cash inflows and outflows.
Consider the following questions.
Do you base your savings rate on gross or net income?
Tax is an expense, just like utility bills or groceries. After housing, taxes are the second highest expense category for many people interested in Personal Finance.
It can be managed, minimised, or avoided altogether… with sufficient planning, risk tolerance and financial acrobatics.
Do you include employer pension matches and tax relief in your earnings?
The perennial favourite refrain of financial planners, that pension contributions result in “free money” via the government offering tax relief on pension contributions.
This sounds like a foolproof offer at first glance, but for someone contemplating early retirement it comes at the cost of having those funds locked away until pension eligibility age is reached.
That doesn’t make it a bad option, but also means it won’t automatically be the right choice for everyone.
Will you include income from all sources (e.g. wages, dividends, gambling, interest, rent, royalties)?
Many people generate income outside of their day jobs. That income may flow into their bank account, or may be channelled elsewhere such as being automatically reinvested via accumulation funds.
The income is real regardless.
If you include that income, for consistency you should also include your investment expenses.
Often times there will be significant costs associated with generating that income, such as financing costs or property management charges.
Investment expenses can form a material portion of a person’s outgoings. There isn’t much point pinching pennies buying groceries that are past their used-by dates if your stockbroker is fleecing you in platform fees!
How about expenses that get deducted for you?
Your employer probably deducts tax and employee national insurance contributions from your pay, before you receive it. These are still expenses. The money was yours, now it is not.
Overseas investments may have withholding taxes deducted from dividends they pay you. This money was yours, now it is not.
Most investment fund operators levy management fees on unit holders, the price they charge for administering the fund. These costs come out of the capital you have invested and/or the income those investments generate. Either way, this was your money, and now it is theirs.
There is a lot of perspective and personal preference that goes on in selecting what gets included and excluded from savings rate calculations. Comparing your own savings rate with that reported by others, without first reconciling the underlying methodologies used, is a fool’s errand.
Analysing savings rate
The real story is told by the underlying numbers. Consider some key questions:
- Are you lifestyle costs being partially/fully funded by your investment income? This could be a sign that you are living beyond your means… or a sign that you are nearing financial independence!
- How has the composition of your income changed over the year? The composition of your expenses?
- Financial Independence is the point at which your passive income covers your lifestyle costs. Are you getting closer or further away from this goal?
You may discover that your lifestyle costs are under control, but your investments are haemorrhaging money.
It is possible you are frugaling yourself into a corner, and can afford to loosen the purse strings and increase your family’s happy factor without significantly adding to your risk or adversely impacting your timescales.
A third lens of analysis that everyone should use, but few people actually do, is monitoring their cashflows.
The previous two metrics looked at what you have and where it came from. Cash flow is concerned with the question of when.
Many financial “emergencies” are really just piss poor management of cash flow, resulting in people being caught short when large expenditures land. A case in point being the alarming regularity with which Christmas or summer holidays seem to take many people by surprise each year!
As a business owner, and somebody who chooses to follow a seasonal working pattern, my own earnings pattern can be very uneven.
Some months there are multiple inflows arriving to fatten my piggy bank. Other months it can feel like I am steadily sinking, like a ship’s captain who has a hole in the bottom of his boat.
Understanding when income is due in, and when expenses are due to flow out, is key to financial survival.
The better you are at managing cashflow, the smoother the ride you will enjoy.
Monitoring cash flow also eliminates much of the wishful thinking that creeps into the net worth and savings rate equations.
For the purposes of cash flow analysis things like: tax relief, taxes deducted at source, unrealised capital gains, and inflated asset prices don’t exist.
Capital gains may make you rich, but cash flow makes you feel rich.
Analysing cash flow
Consider the following questions:
- Are there periods when your income (from all sources) varies significantly from the norm? Examples may include: semi-annual dividend payments, annual bonuses, and tax refunds.
- Similarly, are some months significantly more expensive than others? Examples may include: insurance premiums, tax bills, and seasonal utility bills.
- What level of contingency fund do you need to maintain so that your head stays above water throughout the whole year?
- Do you own assets that are net consumers (as opposed to producers) of cash? If so, do the realistic long-term prospects of that asset warrant bleeding cash to own it?
You may be subsidising the living costs of your tenants, or propping up a zombie business.
Alternatively you may be indulging in holiday homes you seldom visit, or driving clunker cars that are really expensive money pits.
Own your accountability
The exercise of calculating our net worth, saving rate, and cash flow reveal some interesting highlights from our financial journey throughout the year.
Analysis of what is going on beneath transforms those headline figures from interesting to relevant.
This analysis provides us with the opportunity to understand why the figures changed.
To learn from our mistakes.
To make well-informed decisions in the future.
But only if we listen to the numbers, and genuinely hear what they have to say.
And only if we don’t lie to ourselves, if we own the outcomes, and if we accept our accountability.
Why lie, when you can get away with the truth?