Live Large with Planning

Tonight i was asked some interesting questions -

1. what should my net worth be?
2. am i saving/investing enough?
3. should i be debt free?

There is a very interesting book, The Millionaire Next Door that answers some of these questions. It is written by Thomas J Stanley, a professor in Stanford. He studied the wealthy in America and he was surprised that he found the most number of millionaires NOT in swanky desirable addresses but living in middle class areas and most likely neighbours that no one suspected as wealthy. He studied these millionaires and their living and spending habits and published his findings in this book. Not surprisingly, frugality and a strong saving/investment habit was a common finding. Both are wonderful habits but i also believe that life is meant to be lived and the goal should be balance. So i wont focus on the books findings but use one key ratio that was used in that book to answer the above questions. (i do recommend everyone read this book as well. On the path to financial freedom, this is definitely a must read).

Wealth Ratio = Net Worth divided by (Age x Annual Income)/10
Net Worth = Total Assets - Total Liabilities

So if you are age 35 and your net worth is 350,000 and your annual income is 100,000, your wealth ratio will be 1.

This ratio is valuable because it links 3 very important factors in financial freedom - your age, your annual income and your net worth. Breaking this down further as we know that Net Worth = Total Assets - Total Liabilities, we immediately also can link this ratio to the assets we own and the debt outstanding.

Now if your wealth ratio is under 1, the books terms you as a UAW, under accumulator of wealth. If you can exceed 1, you are termed an AAW, average accumulator of wealth. If you are one of the lucky few that score above 2, you are termed a PAW, prodigious accumulator of wealth. I love this ratio as it can be applied universally no matter what your income level is. Your goal is to become a PAW at any income level.

So how do you become a PAW?

Just looking at the ratio, it becomes obvious, increase your net worth (increase assets or reduce liabilities). This ratio can immediately be used to answer all 3 questions above. When your wealth ratio hits 2, you have adequate net worth if you sustain this ratio, you will definitely be saving/investing enough and your debt is adequate. To me debt is not a bad thing BUT it must be managed. The key criteria that you have to ask in increasing your net worth is if i buy the asset is it going to generate a better return than reducing my debt. SO with credit card debt its easy - cost of credit card debt is 12 - 18% p.a and unless my investments can exceed that rate, i would definitely increase my net worth by reducing credit card debt. But, if i have a property that is earning 8% and i have debt at 6%, i would buy the property and keep the debt. The real question is do i have adequate cashflow to maintain that debt and to grow my net assets. The next ratio helps to manage cashflow as well as grows your chances of becoming a PAW.

Savings Ratio = Total Amount Saved/Total Income earned

If you use an annual savings amount, then use annual income but the ratio also works for monthly figures as long as both denominator and numerator use the same base ie annual or monthly.

Now the key here is to have Savings rate above 25%. This means if you earning 10k, you need to save/invest at least 2.5k. This includes your EPF contributions which should be 9 - 11%, so you only need an additional 14 - 16% to be saved/invested. As you track this ratio and the Wealth ratio, you will find that a Savings Ratio at 25% will only let you become at the most a AAW. To be a PAW you will need to be saving/investing at least 35% of your income. This ratio will immediately ensure that you are not taking on unnecessary debt as well as controls your monthly spending.

Its a very simple ratio but very effective in becoming financially free. This ratio also answers the 3 questions above very well.

The next financial tracker answers question 1 and i use this as my long term goal. This tracker is the final piece and ties everything together in financial freedom. The goal is to be financially free. This means a lot of things to many different people but to me, it means not needing my income from my job to sustain my lifestyle.

People ask me when i plan to retire and i answer honestly 45. By the time i reach 45, i will have enough passive income to maintain my lifestyle without my job income. At that point, i will start my own financial advisory firm with the goal of helping others achieve financial freedom as well as to enjoy their lives now. To do this convincingly, i need to achieve financial freedom myself. I enjoy my life as well with the family holidays and appreciating things now. I can do this because every month, i work on ensuring i meet this goal at 45.

Financial Freedom (FF) Net Worth = (Ideal Annual Income - Passive Income) / Rate of return

Now for FF Net Worth, i use a very conservative rate of return, say 4%.

So for example, say Ideal annual income say 240k (20k a month) and passive income (from net rental, share dividends etc) is 60k (5k a month). Then FF Net worth (the net worth required to be financially free) = (240k - 60k)/0.04 = 4.5m.

This means that if i invest 4.5m at a conservative rate of return of 4% and i have passive income of 5k a month, i will be earning 20k a month, my ideal annual income, the income i require to maintain the lifestyle i want.

So in short these should be the goals -

Wealth ratio > 2
As you start your FF journey, dont be discouraged as you will see wealth ratios well below 1. I started at 0.3 and grew to 1.2 and then down to 1 which was a sign that i was spending too much and that my lifestyle had changed with my income level. Its a journey and i am striving to be a PAW as well.

Savings ratio > 25%
25% is the minimum goal. 35% will be ideal. I was hitting over 30% at one time but now it has dropped to 28%. Again, signs for me to control spending and grow investments/savings.

FF Net Worth
Here FF Net worth gives you the actual net worth required to be financially free. Again dont be discouraged by the amount. Even after years of striving, i have only achieved 14%. But, the good news is that as you grow investments (property/shares etc), your passive income grows and the FF Net Worth will actually fall.

Before striving for these ratios - there are three very important goals to achieve first. 1) Cash buffer account of at least 6mths - 1yr and 2) life insurance coverage when you have dependents and 3) medical insurance for yourself and family.

1 is to ensure you dont cut investments too early because of cashflow constraints.

For 2, use the same calculator under FF Net Worth but ideal income is your annual expenses for your family. First calculate what your job already gives you. You just need to get the balance. I recommend TERM life policies. These are the cheapest form of insurance and basically they cover you only if you pass before a certain age. If you are alive at the contract expiry, it is worthless. The good news is that it is cheap and a good way of getting high coverage. Remember if you are paying monthly insurance premiums above 10% your monthly income, you are paying TOO much.

For 3, this is very important. The greatest threat to FF is the inadequacy to handle a serious illness that you or your family may face. Currently, including what my firm provides, i have close to 1m medical coverage with 500k for critical illness.

I hope the above helps as it has helped me on my journey.

Please feel free to drop me a mail at Ramukavisved@gmail.com if i can help further or to even create spreadsheets for you to map the above.