Back in March, I wrote a post called “How To Feel Like A Million Bucks“. I re-read it yesterday, and I’ve decided that the post takes far too long to get to the main points. So I’m rinsing and refreshing it today.
So I’m not officially a financial planner. At least, not here in South Africa, because I haven’t taken the time to write some regulatory tests. And I really should just get my act together and write them. One day, it’ll happen.
And when that day comes, I’m going to continue to do what I already do a lot of: which is step up onto my “adults in their 20s and 30s are crazy about risk” soapbox.
Crazy in two ways:
- Most people tend to be especially careless about their primary asset; while
- Getting obsessively “conservative” with the minor assets.
Which, I think, is mostly a function of not knowing what the primary asset is.
Self-Appraising More Accurately
When most people (and financial planners) calculate their net worth, they do something like this:
- Calculate the value of assets (house, car, savings, provident fund contributions, miscellaneous trinkets of some value);
- Calculate the value of liabilities (mortgage outstanding, car finance, overdraft, student loans, etc);
- Subtract 2 from 1
- And voilà – Net Worth.
This is wrong.
In fact, for a thirtysomething, this is very wrong.
Because, as I mentioned up top (and also in this post on risk diversification), your most signficant asset is missing from that equation.
- Each year, you generate an income by using your skills/abilities/networks.
- You have a limited lifespan within which to generate that income.
- And all the other assets – the homes, cars, savings and trinkets – are the residual leftovers from the proceeds of the income that was generated.
- Let’s call the asset that generated all this income “earnings potential”. Or perhaps “the cumulative education and experience that led to you finding yourself in this position”.
- Either way, for a young adult, that is the primary asset.
- It even earns capital appreciation – by increasing in value as you go on to gain more experience simply by virtue of being in a workplace.
- And as time passes, you draw down on more of it.
- Until eventually, by the time you hit retirement, the asset is fully realised in cash/savings/tangible assets.
And it’s not just the primary asset, it’s also the most valuable one – so to exclude the value of that asset in your equation is, like, insane.
Of course, you also have to include the value of the implied liability (after all, we require maintenance – food, shelter, medical cover, entertainment – so a large portion the asset’s return gets spent each year).
So let me give an example of this calculation.
Firstly, the Simple Scenario
The easiest starting point is to assume that you’ll earn exactly what you earn today (and save what you save, and spend what you spend), for the next 40 years (until you’re 70). And you’ll do that in real terms*.
*I’m going to keep saying “in real terms” because I’m talking about purchasing power. If a 70 year old earns R2 million today – then by the time you turn 70, you should expect to earn the future equivalent of whatever can buy the same volume and quality of goods as can be purchased for R2 million today.
And you then calculate the value of that using a real return figure (let’s call it 2% – because that’s about the historic norm).
Here’s an example:
- Let’s say that you earn R400,000 a year after tax.
- 12.5% of that goes into a pension fund.
- 30% goes into your mortgage bond.
- You manage to save an extra R20,000 a year.
- The rest gets spent on food, clothing, home maintenance and holidays.
What that means:
- Annual real income generated from the asset = R400,000 after tax
- Annual costs of running the asset = R210,000*
*R400,000 – invested income of R190,000 (see below).
- Annual residual income invested: R190,000*
*Pension contribution of R50,000 (12.5% of R400,000) + Mortgage Bond payments of R120,000 (30% of R400,000) + Cash Savings of R20,000 = R190,000
If you were to save R190,000 per year for 40 years, the cumulative total is R7.8 million.
And because the return of the asset is keeping pace with the real return of the economy, the value of the asset is R7.8 million.
As in: that’s what you’re worth today, if your earning and spending habits don’t change.
Then, the Increased Value Proposition
But that’s not realistic, because most professionals represent greater value to society as they go on and gain experience, etc.
So if you assume that your relative worth to an employer goes up by 10% per year until you hit 40, and thereafter you’re up by 5% a year, your real earnings graph looks like this (and for the sake of simplicity, I’m just going to assume that your spending habit stays a constant proportion of your income):
And if earning R2 million a year by the time you hit your sixties sounds like an outrageous assumption, you can check it. All you need to do is look at the people who are further along in the career path that you’re following, and see what they earn today. And if they’re earning more than R2 million a year – then you’re sounding conservative.
Alright, so that’s looking at annual income.
Then if you look at the cumulative real returns (ie. total annual savings “invested” over time), you get this:
If we were to calculate a value of what your increasing-return asset is worth today, then you’re looking at a number of around R22.8 million.
That’s R22.8 million. In real terms. Assuming that your savings only earn a real return of 2%.
The Need For A Paradigm Shift
The trouble is, by excluding the value of this income-generating asset from the calculation of net worth, it means that you’re discounting the value of your largest asset down to zero.
Only, it’s not worth zero.
And if you discount it, it makes you do silly things like:
- Not getting the right insurance to protect that asset; while
- Getting really conservative with the risks on your physical savings.
I say that because most people don’t really think about disability and income protection insurance. It’s kind of an “add-on” that you take with your life insurance policy. IT SHOULD NOT BE AN ADD-ON.
And as for being conservative with the physical savings, someone needs to point out that if you really wanted to get conservative about your net worth, then in order to diversify the risk of having the bulk of your wealth is bound up in a single asset, you’d need to take on a lot more risk by investing in assets whose returns tend to move in the opposite direction to the industry in which you work.
That is: the only way to offset one significant risk is to invest in extreme risks that move in opposite directions.
- Let’s say that you work in the Oil and Gas industry.
- The Oil and Gas industry is obviously heavily dependent on commodity pricing (and specifically, the oil price).
- So if you wanted to diversify, you’d have to invest in assets that tend to go up in value when the oil price goes down.
- To do that, you might choose to invest in the shares/bonds of large retailers and logistics companies – who will either benefit from a falling oil price by having cheaper input costs (like the logistics crowd), or whose customer base will suddenly have more disposable income due to lower fuel prices.
- This approach is inherently more conservative that just investing in a stock index, which might have a whole bunch of underlying companies that are negatively affected by a falling oil price.
- But under the conventional wisdom, investing in specific sectors over the broad index is considered more risky because you’re specifically exposing yourself to a sector of the market that is cyclical.
So here’s my dramatic conclusion: if you want less risk, then you need more risk.
How’s that for a paradox?
Finally, the power of good habits
Let’s go back to those earlier numbers.
New proposition: because you’re a believer in good habits, you decide that you’re only going to let yourself spend 50% of the new disposable income you have arising from any increase your receive (ie. after all those increased pension fund and mortgage repayments). The rest is going to go into a new savings account, and accumulate.
Your new return graph now looks like this:
So what is that worth today?
About R32.3 million.
Making that a roughly R10 million habit.
The Take-Home Messages
- Get good insurance: income protection, disability, health… You have to protect the vital asset. Don’t be foolish.
- Young adults need to take more risks with their money.
- Oh the power of good habits.