Quiz!
What is the most useful measure of a person’s financial health?
- Net worth (total assets minus total liabilities).
- Income.
- Annual savings: income minus expenses.
- Spending rate from stock portfolio: total annual spending divided by the value of the stock portfolio.
- Spending rate from liquid assets: total annual spending divided by the value of all liquid assets (e.g. stocks, bonds & cash).
- Withdrawal rate from stock portfolio: annual withdrawals from the stock portfolio divided by its value.
- Withdrawal rate from liquid assets: annual withdrawals from all liquid assets divided by their total value.
Your Financial Health in a Single Number
People use various numbers to measure their financial health. Let’s review some common ones, and see where they fail, through examples:
| Measure | Person 1 | Person 2 | Person 2 has better financial health | |
| even though… | because… | |||
| Net worth (total assets minus total liabilities) | Net worth: $10M
Annual spending: $1M |
Net worth: $1M
Annual spending: $50k |
His net worth is x10 smaller | His money can support double the years of living expenses |
| Income | Income: $1M per year
Savings: $0 per year Total saved: $0 |
Income: $100k per year
Savings: $20k per year Total saved: $200k |
Her income is x10 lower | She has some financial security in case she loses her job |
| Annual savings | Income: $1M per year
Income taxes: $400k Annual spending: $500k Annual savings: $100k Liquid assets: $200k stocks |
Income: $100k per year
Income taxes: $20k Annual spending: $50k Annual savings: $30k Liquid assets: $60k stocks |
His annual savings is x3.3 smaller | He is building security faster, saving 60% of annual spending vs. only 20%. His savings in stocks are also greater relative to spending. |
| Withdrawal rate from stock portfolio (annual withdrawals from the stock portfolio divided by its value) | Expenses: $1M per year
Stocks: $1M Annual withdrawals: $0k |
Expenses: $40k per year
Stocks: $1M Annual withdrawals: $20k |
Her withdrawal rate is infinitely greater | Her total spending (4%) can be sustained with no work, while the other has only 1 year of expenses saved |
| Spending rate from liquid assets (total annual spending divided by the value of all liquid assets) | Liquid assets: $1M cash
Spending: $40k per year |
Liquid assets: $1M stocks
Spending: $44k per year |
His spending rate is 10% greater | Stocks provide growth, and are more likely to sustain a 4.4% withdrawal rate than 4% from cash |
Is there a single number that can give some indication of your financial health? Yes! It is the spending rate from your stock portfolio: total annual spending divided by the value of your stock portfolio. This assumes that the stock portfolio is diversified, and held for the long run, with no market timing, and no panic sales during stock declines. Also, you can reduce your spending measure by any amount that is guaranteed for life by an inflation-adjusted source, such as social security.
Why does this measure work?
- It shows progress towards financial freedom / financial security / retirement. Once your spending rate is below 3%-4%, depending on the specific portfolio allocation, the portfolio is likely to sustain the spending for as long as you live. If your spending rate is 6%-8%, you know that, between savings and investment growth, 100% increase will make you independent of work.
- It is not sensitive to a loss of job. It ignores income from work, that can be lost in various ways. In addition, if you want to ever be independent of the need to work, you want to measure your position assuming no income.
- It can withstand high inflation, given the focus on stocks.
- It does not suffer from liquidity concerns related to real estate, private equity and small businesses. Exception: If you have a diversified collection of properties, you can consider their income, after accounting for vacancies and repairs, if they are diverse geographically (and ideally enjoy country diversification, same as with stocks).
- It focuses on current health instead of potential. Even if you save a large amount every year, the saving can stop completely if you lose your job. What matters is money on hand (prior savings).
What are the implications? How can you improve your financial health?
- Maximize your allocation to stocks, but not beyond the point of risking getting into trouble during stock declines, either through large withdrawals, or panic sales. This requires a careful risk analysis.
- Keep your spending under control. A 10% reduction in spending provides an instant 10% gain in your financial health – this is powerful.
- Maximize your savings, either through lower spending or higher earnings. Note that higher earnings will not have any immediate impact, but the saved money from your increased earnings will build up gradually.
Quiz Answer
What is the most useful measure of a person’s financial health?
- Net worth (total assets minus total liabilities).
- Income.
- Annual savings: income minus expenses.
- Spending rate from stock portfolio: total annual spending divided by the value of the stock portfolio. [The Correct Answer]
- Spending rate from liquid assets: total annual spending divided by the value of all liquid assets (e.g. stocks, bonds & cash).
- Withdrawal rate from stock portfolio: annual withdrawals from the stock portfolio divided by its value.
- Withdrawal rate from liquid assets: annual withdrawals from all liquid assets divided by their total value.
Explanations: See article above. Note that the last option “withdrawal rate from liquid assets” is not addressed by the article, since it suffers from the combination of flaws of the two options above it (5 & 6).
Disclosures Including Backtested Performance Data