If you want to go down a rabbit hole Google “does money buy happiness”. There are countless opinions and studies measuring happiness and life satisfaction against financial milestones.

After spending hours reading, I’ve come away with a couple conclusions that largely align with the way I view my own finances. The first is that financial insecurity is a huge source of stress. Constantly worrying about how to cover the necessities of life including a place to live, healthcare and having enough to eat is truly debilitating. Far too many people in suffer from this worry every day.

The second is that after these basic needs of life are met the satisfaction we get from improved financial circumstances diminishes. There is some argument and conflicting studies whether satisfaction plateaus at the oft cited salary of approximately $75,000 US or if it keeps growing as more wealth is obtained.

However, most studies agree that each wealth milestone reached after meeting our basic needs results in a diminishing level of satisfaction. Ironically some studies indicate that some people who reach high levels of wealth believe that it brings more problems than it solves. Over 1/3 of those with more than $10 million in assets indicated their wealth was more trouble than it was worth in a PNC Advisers study.

Many readers will scoff at this notion that a higher net worth brings about more stress and lower life satisfaction. On the surface it is a ridiculous proposition. But I also think it is illustrative of how we measure financial success and the inherent issue with our view of what financial success entails.

In popular culture financial success is measured by net worth. The word millionaire is a noun. Yet we often use it as an adjective - the millionaire philanthropist, the millionaire investor, etc.

Using a measure of net worth as a descriptor tell us a lot about the importance that society places on how much money each of us manages to obtain. We view it as central enough to what and who a person is to add it as a descriptor. Depending upon your point of view it could be a positive or negative moniker. The point is that it matters.

The larger issue is that this view of financial success drives the way we approach managing our money and the goals we set for ourselves. It ignores the true value of money as an enabler of security and happiness. Money and wealth are a means to an end. Treating it that way can change your relationship with money and the decision-making process for your own finances.

The last conclusion from exploring studies linking money to happiness speaks to this point. These studies focus on what type of spending brings people joy. The evidence is overwhelming conclusive. People are happier when they are spending money on experiences like travel or going out to dinner. Spending on possessions does not increase our happiness.

Net worth as a measure of success

Net worth is a flawed measure of financial success. Reaching the milestone of becoming a millionaire tells us very little about how money impacts life satisfaction and happiness. Perhaps that is the obvious reason why there are so many conflicting answers to linkages between levels of wealth and happiness.

The reason net worth tells us little about life satisfaction and happiness is because it tells us very little about day-to-day life. Some millionaires are heavily indebted to maintain their asset base and may struggle each month just to pay bills. In this case there may be very little money left over to spend on whatever brings joy to life which we can safely assume is not paying bills.

Some people with far lower levels of net worth have more choice and freedom on how they spend money. Many of us save and invest to achieve financial freedom. The definition of financial freedom means different things to different people but most of us can agree that choosing how we spend our money and time is synonymous with freedom.

Not only is the day-to-day experience of two people with the same level of wealth different but in a real-world sense there can be vast differences in the spending power associated with assets valued at the same level on paper. Holding $1m of shares that have appreciated 50% in a taxable account is worth far less after-tax for an owner in a high marginal tax bracket than if they were held in super. Some assets like real estate have high transaction costs to sell. Cash has no transaction cost and can be immediately spent.

If we think about net worth as a function of what it can buy, where you live matters. The cost of living in different parts of Australia and different parts of the world are vastly different. There are countless other considerations, but the central point is that a given level of net worth means different things under different circumstances.

Cash flow is king

If we are going to measure our wealth as the combined value of the assets we own we should consider the source of their value. At a surface level the value is what someone is willing to pay. This often volatile measure of what something is worth ignores the fundamental underlying value. The way that we value anything – a bond, a piece of real estate, a share or a small business – is based on the present value of the future cash flows generated.

This is not only a governing principal for investing but also for life and how to manage your own personal finances. If you are entitled to a stream of future cash flows that has value.

That could be a dividend paying share, it could be an annuity, or it could be a pension from the government. Anything where money flows into your bank account in the future is an asset. Conversely anything that has negative future cash flows including a loan, rent, or a subscription is a liability. Anything you own which will cost you money to maintain in the future is also a liability.

We can use a car as an example. If you buy a car with cash you may think you are just acquiring an asset without future obligations since no financing was used. In reality you are signing up for a stream of negative future cash flows. There is insurance, registration, petrol, and maintenance costs. All of those costs are likely higher if a nicer car is purchased. Even if you meticulously care for your car it will depreciate quickly. All physical assets depreciate. Thinking about the purchase of a car in this way brings to life the adage that our possessions come to own us.

Some things you spend money on are not one-time purchases. In a cash flow view of the world these recurring obligations are more like debt. Even if they don’t actually involve borrowing money they are borrowing against your future earnings or any wealth you’ve accumulated.

If you take out a subscription to Netflix for $25 a month it may seem like a small price to pay for entertainment. But it isn’t just a one-time purchase. It is a recurring negative cash flow.

The decision to take a Netflix subscription may seem inconsequential. And in the big scheme of things that might be true. The problem is that many of us eat up more and more of our salaries with these fixed obligations. Some easy to get out of and some harder. And we are encouraged to do this based on the availability of credit and the seemingly small sacrifices to get ‘something better’.

Perhaps each of these one-off decisions makes sense in isolation. Paying just $100 or $200 extra a month to get a ‘better’ car seems like a small sacrifice to some people. Yet in aggregate they put a straight jacket around our finances. As more and more of our spending becomes fixed the discretionary portion of our cash flow shrinks. That reduces the choice we have over our spending and limits our freedom. It makes it harder to obtain financial independence.

Fixed vs discretionary spending

How much of your salary is truly discretionary? Discretionary means money that you have total choice over how you spend it. Going out to dinner – even a very expensive dinner – is discretionary. If you are not taking on debt to do it that dinner is a one-time expense. It has no impact on your future spending the way an ongoing obligation does.

There are many ways to categorise spending. And most of the budgeting advice we get is around tracking spending and putting it into categories. I find this approach and any budgeting exercise exhausting. To me it provides an illusion of control over spending but misses the larger point of using financial assets and earnings power as an enabler of happiness.

Budgeting advice is almost always about giving up discretionary spending. Skip the morning coffee, meal prep instead of buying lunch – the examples are countless. Giving up the small pleasures in life to save in a way that doesn’t feel like it is leading to financial freedom is not sustainable. Often this saving is sold as a mechanism to go into debt in the future. It is a way to save up for a downpayment on a bigger home or a fancier car.

We can use the 50/30/20 budget rule as an example. The premise is that 50% of earnings are spent on needs and obligations, 30% on wants and 20% on savings and debt repayment. My issue with this approach is there are lots of grey areas about what is a need and what is a want. Sticking to this budgeting approach is a formula for lifestyle creep because each additional dollar of cash flow is divided into the same buckets.

Each salary increase turns a want into a need as we get used to a ‘better’ lifestyle. The availability of credit and all the various services we can subscribe to means most of these so-called improvements in living standards will be ongoing future obligations that move us further away from achieving financial freedom.

We can get used to discretionary spending as well. Yet this spending on experiences is fundamentally different than spending on something that comes with an obligation in the future. Buying a more expensive house comes with greater ongoing spending requirements to pay the mortgage and for the upkeep of the house.

I believe the goal over time should be to increase the amount of your personal cashflow that goes to what I consider discretionary spending. And to me discretionary spending is everything that is not a regularly recurring cost in your budget – that includes a mortgage, rent, car payments, subscription services, insurance fees, gym memberships, etc. Whether you consider this a want or a need and whether it is easily cancellable or not doesn’t change the fact that it is all non-discretionary spending.

Since happiness comes from spending on experiences it makes sense to be deliberate about entering into any ongoing obligations. The largest of these expenses is housing. Buying a house is an obvious example as a long-term and large mortgage is often a requirement. Owning a house also requires a lifetime stream of maintenance costs. Rent is also an ongoing obligation. While not a contractual obligation for more than a year generally it is necessary to have a place to live. And that costs money.

This is not a call to not buy a house or spend money on rent. It is a call to be deliberate about these large obligations. Many people outsource this key decision that will substantially influence future finances. A term that is casually thrown around is borrowing power.

All things being equal the higher your salary the higher your borrowing power. Who determines your borrowing power? The bank. Letting a bank tell you the cost of the house you can afford to buy and then following that guidance is effectively outsourcing the biggest contributor to your day-to-day budget. In the 1970s a bank in Australia couldn’t lend more than 2.5 times a person’s salary. Now it is 4 times salary. As a society we just mindlessly followed this shift in standards and called it progress.

For most people this world of abundant consumer credit means a higher salary equals more debt. We wilfully exchange increases in our cash flow for more obligations against our future earnings. Effectively we are taking a positive outcome which can give us more financial freedom and turning it into an enabler of our long-term financial servitude.

The approach I’ve outlined is not a budget. It isn’t a call to not spend money. It is an underlying philosophy on how to think about your personal financial situation. As we age salaries typically increase. This is a chance to thoughtfully consider how much non-discretionary spending is increased. It is also a way to think about achieving financial success through saving and investing because growing your personal cash flow is the real recipe for success.

How a cash flow focus impacts investing

Before getting into what I think you should do it is worth focusing on why people don’t think about investing in the right way. A focus on increasing net worth can lead down a path that may not align with the type of life you really want to live. Many investors don’t bother thinking about their investment goals. In a net worth obsessed society the goal seems self-explanatory. It is to have the most money possible.

There are several reasons why this seemingly rational goal does not work in practice. Logically a focus on wealth maximisation means always owning the highest returning investment. This mindset becomes persuasive and leads to decisions that ultimately are not in an investor’s best interest. It leads to chasing the hottest trend and whatever sounds like the best narrative. It leads to over trading.

It also leads to more debt. We often call this good debt because it is being funded to purchase assets. Every increase in salary can fund more debt. A larger mortgage means a more expensive house which in theory can appreciate more on a dollar basis. Equity built up in a home can be used to fund the purchase of negatively geared investment properties.

Maybe on your personal balance sheet this will pay off at some point to maximise your wealth. But will it maximise your lifetime happiness? Will years of negative flows be worth it? More importantly, have you even considered if this trade-off is what you want?

If spending money on discretionary experiences makes us happier our investments should enable more of that spending. I have written numerous articles on why I’m an income investor. I discussed why I don’t believe the critiques of income investing are accurate. I’ve talked about how to build an income portfolio and why I believe income investing reduces behavioural risk. Yet the crux of the argument for income investing is simple. If increasing personal cashflow is a pathway to a more satisfying life my investments should generate cash flow. Not when I’m retired. Right now.

Even if the dividends received from an income portfolio are not spent immediately it is empowering to grow that income stream. Increasing my personal cash flow is empowering in a way that watching my net worth slowly climb never can be. And I have started spending them. I am hopefully far my death bed. Yet I know when I get there the measure of my life will be my accumulated experiences and my investments are helping to pay for them now. 

Each time I save and invest $1000 I am not thinking about my net worth increasing. I am thinking about the $40 a year I get in dividends. That same $40 I get each year for life will grow at a rate higher than inflation if historical dividend growth continues. These small sacrifices are a pathway to financial freedom and a better life. It may seem counterintuitive to save and invest while using dividends to pay for life experiences. I disagree. I am slowly buying my independence with my saving while reaping a small part of the rewards now. 

Final thoughts 

I understand that this concept is different from what we are typically told. We are told to focus on our net worth. To use debt as an enabler of acquiring more assets. To find tax minimisation strategies involving negative gearing to sacrifice current cash flow for a lower tax rate. To focus on growth investing when we are young and only worry about income when we are retired.

We are told someday this will pay off. Someday we will be able to sell our assets to fund the experiences we really want now. That when we sell those assets, we will still be young enough to enjoy the experiences they buy.

Until then we will focus on our net worth, keep acquiring possessions and keep lying to ourselves. We will tell ourselves that these possessions are enablers of what we want. The big house with the big yard will create memories with our family and friends while creating a better life in the future.

And while we think about all the great things these assets will add to our lives we will miss the opportunity to experience them as we keep working long hours to pay them off. And on we trudge, buffeted by the headwinds, towards an unappraised mirage of financial success. 

If this isn’t the approach for you here are some suggestions:

  1. Create your own version of financial success and goals that matter to you: A focus on simply growing your net worth may end up enriching banks, fund managers, attorneys, financial advisers, and accountants at the cost of your own happiness.
  2. Focus on growing the portion of your salary going to discretionary spending: Don’t use salary increases to fund more fixed obligations and instead pay for experiences. Battle against lifestyle creep that doesn’t bring you joy and simply resets your expectations for a life you may not even want. Remember that choice over your spending is true independence.
  3. Use your savings and investments to provide cash flow: Use your investments to create a growing income stream. The more cash coming into your bank account the more options you have. Those options will provide freedom.

 

In part 2 of this article I will describe how I settled on this approach.    

What do you think of this approach to personal finance? Have you taken a similar or different approach and how has it worked out? I want to hear at mark.lamonica1@morningstar.com