How financially healthy is your household?

You might look at your super balance, the value of your home or the size of your investment portfolio to answer that question. But these numbers only tell part of the story.

A household can have a growing net worth while becoming more financially vulnerable. Debt could be rising, savings could be falling or too much wealth could be tied up in a single asset.

In this episode of Investing Compass, Mark LaMonica and Shani Jayamanne look beyond net worth at four simple ratios that can help investors understand the strength and resilience of their overall financial position.

You can find the full article here.

You can find the transcript below:

Mark LaMonica: Welcome to another episode of Investing Compass. Before we begin, a quick note that the information contained in this podcast is general in nature. It does not take into consideration your personal situation, circumstances, or needs.

So, Shani, I got a message from my mother this week. And our book, she got it into Greenwich Library in the US. So that’s a town that I lived in. And she’s very excited. And she wanted me to tell you about it. I’ve told you previously. So, this is not…

Shani Jayamanne: Oh, I thought I had to feign excitement, like it was the first time.

LaMonica: No, we’re not testing your acting abilities. But anyway, my mother is very excited.

Jayamanne: Meanwhile, all of my requests for City of Sydney Library have gone unanswered.

LaMonica: It’s in libraries in Australia.

Jayamanne: Just not ours.

LaMonica: Yes. And it’s also in libraries in the U.S. There’s like nine copies in the Los Angeles Public Library system. And you can go in and check. And last time I checked, three people…

Jayamanne: Had checked it out.

LaMonica: …had checked it out. They’re probably going to be disappointed with some of the references to…

Jayamanne: To superannuation and tax and…

LaMonica: Exactly. You know, the strange spelling use everywhere. But let’s get into the episode. So, this is one you came up with. So why don’t you introduce this?

Jayamanne: Okay. So today we’re going to focus a little bit on your end of financial year review. And we’ve waited for the dust to settle a little bit after the 1st of July because many of us need to wait for annual statements, tax statements, et cetera, and the like before we can actually start the full review with our portfolio.

LaMonica: Now, where this started is you wrote an article last year basically saying here are some indicators if you are wealthy and whether you have grown your wealth relative to the previous year. And so, we’ll put a link to the article in the bio. And net worth is sort of the obvious thing there. But it’s also important to look a little deeper past the surface.

Jayamanne: So, you can also look at your savings rate, your cash flow year-on-year, your debt to income ratio, and your required rate of return. And improving these numbers year on year are decent indicators that you’re growing your wealth and can be benchmarks with which you can measure your success. But I also wanted to look at the opposite side of the equation, how you measure risk in your portfolio.

LaMonica: Yeah, which I think is just as important for your success, and of course, the likelihood that you reach your goals, which is what we always talk about. So that’s what you did for this end of financial year review. So, you had a look at the measures of risk that you can monitor so you can identify problems before you run into them.

And I did talk about net worth before. A lot of people just use that simple check. So, they check their financial position by adding up their assets, so their house, their super, any other assets they have, and then of course subtracting any debt. And if it’s growing each year, that of course is a good sign. But a growing investment portfolio can disguise a deteriorating financial position if your debt is rising even faster. A large super balance might look impressive, but it won’t help if you don’t have emergency savings, or you just struggle on a month-to-month basis to meet your expenses. So, it is important that you do have this context of risk when you’re doing these reviews.

Jayamanne: Okay, so let’s start with the first measure, and that is liquidity. And it is an indication of how you can meet your obligations if something unexpected happens. And so, the liquidity ratio can help you with this. And it’s your accessible cash divided by your monthly expenses. So, for example, if you keep $45,000 in an offset account and your expenses are around $7,500 a month for essential living costs, your liquidity ratio is six months.

LaMonica: And we do want to be careful to say that obviously if you’re just looking at your liquidity ratio, you can just keep holding more and more cash to make this look more impressive.

So, there’s an opportunity cost to holding cash, and it generally earns lower returns than growth assets over long periods of time. So, you do need to fine-tune this. You need to get the balance right. So that opportunity cost needs to be weighed against the benefits of cash. And that’s of course the liquidity that it provides if something goes wrong.

Jayamanne: So unexpected redundancy illness, major home repairs, or family emergencies never really seem to arrive at convenient or predictable times. And investors who have a decent amount of liquidity are less likely to be forced to sell their investments during market downturns or take on expensive debt when life doesn’t go their way.

LaMonica: And like we always preach, and like everything else in personal finance, the right level of cash for you depends on your own circumstances. So, if you live in a dual income household with secure employment, you may need less liquidity than a self-employed contractor who has big months and then dry months. So, the ratio isn’t about chasing some sort of magic number. It’s about understanding whether your household has enough breathing room and whether you need to create some more.

Jayamanne: Okay. So, then you have your savings ratio, and that is your annual savings divided by your net household income. And really, this looks at the question of whether you’re focusing on what you can control or are you heavily relying on rising asset values to do the heavy lifting for you. And if you’re doing the latter, your savings ratio can be a good indicator of improvement year-on-year.

LaMonica: And this was an interesting one because that is part of your indicators of wealth that we talked about, but it can also be an indicator of risk. So, we do tend to focus a lot on market returns. They’re much more exciting than saving money, but your savings rate is one of the few variables in investing that are completely within your control and consistently saving more over long periods of time can supercharge that wealth creation. And it is guaranteed, unlike market returns.

Jayamanne: And Australian life expectancy has risen 30 years in the last century. Most Australians need to save enough for a retirement that is likely to be the same duration as their working life. So, it’s a mammoth task that does require focus. My investment strategy focuses on the variables that are within my control. So that includes my savings rate, behavior, minimizing taxes and costs. And it can make a much larger difference to your return outcomes and agonizing over two similar investments.

LaMonica: And like a lot of the other ones we’ve been talking about, this ratio also acts as an early warning system. If your income rises, but your savings ratio remains unchanged, that means that there is lifestyle inflation going on, and it could be quietly consuming more and more of every one of your pay rises. So, in other words, it’s lifestyle creep.

So, let’s move on to leverage, Shani. Borrowing isn’t inherently good or bad. If you’re someone that is using it sensibly, leverage allows households to buy homes, invest and smooth spending over their lifetime, but you’re not getting all that for free. It also magnifies risk.

Jayamanne: And rather than focusing solely on the size of your mortgage or investment loans, consider your leverage ratio, which is total debt divided by total assets. A household with $2 million in assets and $600,000 of debt has a leverage ratio of 30%. This provides additional context than simply saying you have $600,000 in debt.

LaMonica: And your leverage ratio should also be viewed with some context. And that context is your capacity to service that debt. So rising interest rates, changes in employment, or growing family commitments can all make what feels like a manageable level of borrowing into a financial anchor.

Jayamanne: And importantly, not all debt serves the same purpose. Borrowing to purchase appreciating assets may have very different long-term outcomes than borrowing to fund consumer debt or consumption. The ratio doesn’t distinguish between good or bad debt, but it encourages households to understand how much financial risk that they’re carrying overall.

All right. So, we’re going to move on to the last ratio, which is concentration. Concentration does create risk.

LaMonica: And many Australian households, unknowingly, have much of their wealth tied to a handful of drivers. Their income comes from one employer. Their largest asset is the family home. They’re super and share portfolio or heavily invested in Aussie equities. If they also work in banking or mining, they have even more concentration in those same parts of the economy.

So simple way to assess this is to calculate your largest asset divided by your total household net worth. So, if your home represents 80% of your wealth, that’s useful information. It doesn’t automatically mean you’ve made a poor decision, but it could help you to direct future savings. It’s worth understanding how much of this wealth you stand to realize and how concentrated your outcomes are on one asset.

Jayamanne: And I’m an example of how circumstance can lead to concentration. I’m an advocate for diversification, but a large part of my portfolio is in one holding, and that is Morningstar. It is part of my remuneration package. I work in financial services and my skills and experience are aligned to the industry. So, with over 30 years to go until I access my superannuation, my assets are heavily concentrated in equity markets, which locally are further concentrated in financials. I have a mortgage on a property in the Australian market, and that is just a lot of concentration. But I do understand the concentration in my portfolio and also the context of my multi-decade time horizon.

LaMonica: And we should say, and hopefully you’re one of these people that concentration can work in your favor. Many of the best investment outcomes have come from investors having meaningful exposure to great businesses. But you’ve just got to be aware that this concentration does change the nature of risk. When a portfolio depends heavily on a small number of outcomes, you’re no longer just taking market risk. Instead, the primary risk is your ability to assess if the investment that you’ve chosen is correct. So, it’s basically the risk that you do something wrong. And I’m not saying that this is not the right thing to do. There’s plenty of investors that deliberately make concentrated bets because they have a very high level of conviction.

Jayamanne: And ultimately, it’s important that the level of concentration in your portfolio is a considered decision and not something that you have drifted into without noticing. Concentration increases vulnerability and a downturn in one market, industry, or region can have an outsized impact on your financial position. The objective isn’t to eliminate concentration altogether, as it’s pretty impossible to do this without a significant base of assets. But you’ve just got to recognize where it exists so future investment decisions can improve diversification over time.

LaMonica: And what’s really important about all these ratios is that they do need some context. So as soon as you start measuring something, it’s really easy and tempting to automatically declare if that is good or bad. There’s no right range to fall into with any of these ratios. It really depends on your circumstances, your goals, and then trying to create that balance in your financial life.

Jayamanne: And in the case of the ratios that we’ve spoken about today, when you focus on improving one, it might just worsen the other. Holding more cash strengthens your liquidity ratio, but might reduce long-term investment returns. Paying down debt lowers leverage, but might delay investing elsewhere. Concentrating your wealth in a successful business may reduce diversification while substantially increasing your overall net worth.

LaMonica: And all of these ratios, they’re useful when you track them over time rather than just viewing them in isolation. So, a single snapshot tells you where you are today, but repeating this process over time tells you whether you’re moving in the right direction.

Jayamanne: And we’d like to end this by saying that good decisions start with a good understanding of your circumstances. These ratios allow you to see progress over time. So, continue measuring them into the future with your end-of-financial reviews. See a pattern about where these ratios are heading because risks are as important a measure as success is. Successful investing isn’t just about growing assets, it’s about building resiliency and flexibility that supports the life that you want.

LaMonica: Yeah. And I think that’s what they give you. They give you this indicator of financial resilience. We talk about financial resilience a lot on here. So, hopefully you can show whether you have a strong portfolio or one that potentially is very much at risk if the market reverses. And the same thing with your other financial condition.

So, I do hope that this helps. Shani’s article is linked in the podcast notes. And if you can’t get to the Greenwich Library, you can purchase our book from Amazon or Booktopia. So, thank you very much for listening.

(Disclaimer: Any advice in this podcast is general advice or regulated financial advice under New Zealand law prepared by Morningstar Australasia Proprietary Limited and/or Morningstar Research Limited without reference to your financial objectives, situations or needs. You should consider the advice in light of these matters and any relevant product disclosure statement before making any decision to invest. To obtain advice for your own situation, contact a financial advisor.)

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