Future Focus: Are you wealthy?

As 30 June rolls around, many investors start taking stock of their investments and overall financial positions. End of financial year (EOFY) is a natural point for reflection. Your investment, superannuation and bank providers will send you annual statements that do a lot of the hard work for you.

These statements provide an overview of your accounts which provides a holistic view of your earnings for the year.

It is often tempting to look at the increase in your net worth from year to year – who doesn’t want to know the changes in their financial position over the last 12 months? This is just one yardstick. I think there are additional ways investors can make the most of a EOFY review.

Indicators of wealth

There are a few numbers to look at to review your financial position and whether it has improved.

Your net worth

When we think about wealth and wealthy people, we’re often focused on net worth. This is the view of wealth we are presented in rich lists and rankings of the most affluent people in Australia. For everyday individuals who don’t have hundreds of millions of dollars, a more productive prism to view progress is real wealth. In this case we examine the impact of your wealth in contributing to a meaningful difference in the quality of your life.

Yes, net worth does matter. It’s a long-term indicator of your ability to build wealth. However net worth is just a paper figure that constantly fluctuates. A large portion of net worth is typically tied up in illiquid assets which often comes with a significant amount of debt - especially in Australia given the high cost of housing.

For the net worth tied up in an illiquid asset to contribute to your life there needs to be an exist plan. Especially if your investments are cash flow negative.

It’s very easy for individuals to obsess over a net worth figure since it is how society often views wealth. I see it all the time on social media where somebody will proclaim ‘I’m worth $3 million at age 30.’ This is clearly an admirable achievement but is an incomplete view without disclaimers on the amount of debt associated with assets, the restrictions on funds locked up in super or the inclusion of depreciating assets like motor vehicles. A single number is not a reflection of an individuals quality of life or financial strength.

The obsession with net worth can also drive poor decision making. The more you hear about high returns the more you are inclined to chase them if you have a short-term focus on your net worth. When the market is falling your net worth fixation makes it more likely you will sell.

I’ve outlined several factors to focus on as an investor that are more productive than simply tracking your net worth.

Your savings rate

For those earlier in their wealth-building journey savings rates are critical. High-income earners often focus on how much they earn and not how much they keep. People underestimate how powerful a high savings rate is early in life. Without saving money it is impossible to gain financial independence.

If you’re saving 50% of your income, you only need to fund one year of lifestyle with one year of work. That’s a powerful mindset shift.

Personally, I place a large focus on savings rates in my own investment strategy. I try to focus on what I can control. If I’m contributing $100 a week to my investments and I manage to save an extra $10, that’s effectively a 10% return. Managing your savings rate and making sure it’s sustainable over the long term can supercharge your wealth creation.

Cashflow Year-on-Year (YoY)

There are several key indicators you can use to assess how much real wealth you’ve generated. One is cashflow. Most of us live on a cash flow basis: income comes in, expenses go out.

Wealthy people shift from earning wages to being paid by their investments. Instead of tracking asset value, they track the income those assets generate (dividends, interest, rent).

Tracking how much income your assets produce is one way to measure progress toward financial independence. Another is tracking how close you are to replacing your employment income or covering your basic living expenses. This provides a tangible measure of independence as you rely less on wages and increase your options in life.

A useful ratio is the passive income ratio:

Passive income ÷ Total expenses

Being able to compare your cashflow year-on-year will give you an understanding of how close you are to closing the gap between your lifestyle and your portfolio. The narrower it gets, the more choices you have.

However, it is also important to track whether it has at least grown with your personal inflation rate. Lifestyle creep can quickly erode any advantages from an improving financial position.

Your debt-to-income ratio

A debt-to-income ratio compares your debt payments to your income. It helps you understand how much of your income goes toward repaying debt. Over time it indicates the amount of progress you’ve made based on your ability to increase income, pay down debt, add to your cash cashflow and improve your liquidity.

Many definitions of debt-to-income describe it as comparing your debt payments to your gross income. I prefer to compare debt to net income. Comparing it to gross income is misleading. How is a comparison to your income prior to removing superannuation, tax and student payments to the ATO helpful?

Aussies typically hold a lot of debt – both mortgage debt and consumer debt. TAn improving ratio indicates that debt is less restrictive to your freedom of action.

Liquidity is also an important consideration. Reducing your debt provides more liquidity which also sometimes called runway.

The purpose of real wealth is to acquire freedom and flexibility. Having liquid assets gives you the ability to make lifestyle choices. A good starting point is an emergency fund. It provides peace of mind and lets you deal with unexpected circumstances. But a broader liquidity buffer does more as it not only protects you from emergencies but also positions you to take advantage of opportunities.

If you own multiple investment properties your net worth may be substantial, but if you’re servicing multiple mortgages and stretching your employment income to do so your freedom may be quite restricted. If a dream job opportunity comes up overseas and requires a pay cut you might have to turn down. You’re tied to your assets and that limits your freedom.

Having a liquidity runway of assets that aren’t locked away gives you flexibility. It allows you to make lifestyle choices. Freedom of action is a true indicator of wealth.

Your required rate of return

This is less about the wealth you have now and more about whether you are on track to reach your financial goals. This is the figure that shows your progress in building life. Most people are building wealth for the sake of it and instead want that wealth to deliver a specific benefit later in life.

Your required rate of return is the output of properly defining your financial goal. It represents the per annum percentage return needed to achieve your financial goal.

The required rate of return depends on your savings rate, the performance of your investments and your timeline to achieve your goal. As those variables change the required rate of return changes.

For example, I might have originally calculated that I need a 6% p.a. return to reach my goal of a house deposit in 5 years time. A year later during my financial review I may have discovered that due to extra savings this year my 6% p.a. return has dropped down to 5% p.a. I’ve improved the chances of reaching my goal and increased the chances of reaching my goal earlier.

Context is required for these indicators

A metric is only valuable if you understand how it impacts your life. Everyone is different. Some people are risk seekers and do not mind being leveraged to the hilt. Others feel extremely uncomfortable with debt.

Many Australians that are looking to build wealth are suffering from ‘mortgage stress’. The official definition of mortgage stress is having more than 30% of pre-tax household income goes towards a mortgage. Given the cost of housing many homeowners have little way out of this situation.

However, mortgage stress is an arbitrary metric. At different levels of income being in mortgage stress would have different impacts on your life. For people with a high income you can still save, live your life and have an adequate emergency buffer. At lower levels of income this may not be possible.

Part of a portfolio review or ‘reset’ is reflecting on not just metrics or ratios, but also what kind of financial situations that cause you stress.

Underappreciated indicator of progress

How do you feel about your financial situation? For me, the most underappreciated indicator of an improving financial situation is peace of mind. Just spending less time worrying about each small purchase or bills and obligations is a blessing.

More Australians are experiencing financial stress and anxiety due to challenging market and economic conditions. This is a measure of financial well-being that often isn’t acknowledged. This is one area where building financial freedom often dramatically improves your quality of life. It isn’t just what you are able to afford, but the mental security wealth affords you.

When you’re looking to build wealth, there’s no single indicator that’s better than the other. The goal should be to reach a place where you have both long-term investments that build your net worth and liquid assets that give you freedom of choice. That’s what real wealth looks like.

Wealthy people with large asset bases are able to do both. A high net worth is naturally required to have a sustainable, recurring passive cashflow. However, a high net worth doesn’t always translate to a better quality of life or financial freedom.

I’ve identified indicators I believe are useful to track progress towards financial goals. Just remember that investing is a means to an end. Ultimately, wealth is about choice and giving yourself options and independence. This EOFY reflect on whether your investment strategy and assets are contributing to achieving a better life.