Are You Looking at a Video or a Photograph?
We’ve all been there- at an amazing party where we look stunning, have a great time and only leave when we absolutely have to. And then we see that one photo from that same party where we look like something out of a horror film. What’s this have to do with your finances? Everything- especially in times of volatility.
Even the most financially savvy folks have times when their financial picture doesn’t look as attractive as what it really is in the long term. To avoid making terrible mistakes, you need to understand how you are looking at your finances so you can make successful long-term decisions. The easiest way to help you see what we see and are looking for is to give you some examples.
A Personal Financial Statement is a photograph of a moment in time of your life. Your long-term cash flow projection is your video. Let’s assume we are looking at a Personal Financial Statement that looks like this:
Savings Account $50,000
Retirement Account $20,000
Total Assets $395,000
Student Loan ($150,000)
Car Loan ($20,000)
Total Liabilities ($410,000)
Total Net Worth ($15,000)
This looks like a pretty scary situation- but what if it’s for a fully insured 32 year old doctor with a $300,000 income who is just starting out, and has established a good long term savings plan? Not so scary, then. As a matter of fact, this woman’s long- term cash flow projection (video) probably looks amazing given that she’s been disciplined enough to build a savings account of that size. If she keeps her expenses to less than $100,000 and continues to build savings and retirement while paying down the student loan, her future looks bright!
Look at this picture (Balance Sheet):
Savings Account $50,000
Retirement Account $2,000,000
Total Assets $3,150,000
Personal Line of Credit ($500,000)
Car Loans ($80,000)
Total Liabilities ($1,380,000)
Total Net Worth $1,770,000
With almost a $2,000,000 net worth, this looks like a pretty good picture. But then you find out it’s a 70-year-old lawyer who makes (and spends) well over $500,000 a year and has to retire. That long-term cash flow projection (her video) is not going to look very pretty. We believe if she doesn’t dramatically cut her lifestyle, she’s going to run out of money very quickly- even though she is a millionaire!
This time, it’s a 55-year-old executive making $350,000 annually and the stock market has been tanking over the last 3 to 4 months at the time this was taken.
Savings Account $150,000
Brokerage Account (bonds) $150,000
Retirement Account (stocks) $1,700,000 (Had been $2,500,000)
House $500,000 (Was $600,000)
Total Assets $2,570,000
Car Loans ($30,000)
Total Liabilities ($380,000)
Total Net Worth $2,190,000
Should she freak out with the market being down? Assuming that portfolio is diversified and holds quality, non-speculative holdings- probably not. While this picture of her doesn’t look as attractive as one that may have been taken 6 months ago, she has plenty of time until she needs to take income from her investments. Further, if she lost her job, she has a nice cushion to take care of her until she can get another gig. Her debt to income ratio is very reasonable. Her video looks very good to us, even though it’s not the best picture right now.
Last one: 70-year-old widow who has decided she is not investing at all. She has $36,000 coming in from Social Security and spends about $100,000 a year in today’s dollars. She has a paid off house and no debt. She has almost a million dollars sitting in a bank account earning very little. How does her video look? Not pretty. While she thinks she has enough to last 10 years (her mom died when she was 80), what happens if she lives past her mother’s date of death? What does she do with inflation pushing up her expenses each year? What does she do when she has a non-standard expense, like an uncovered medical cost? This video could go either way, but if she’s trying to avoid a bad picture by taking on no risk, she may be creating the worst video of all- slow death.
So, what are the basics to making a good video of your life? Here are some basic tips:
- Keep your spending and debt to income ratio in check- always.
- Leave plenty of room in that budget to save for the future.
- Have appropriate risk management tools in place- liquidity and insurance where needed are critical to keeping the video better than any crisis photo that comes up.
- Build quality assets. Houses, cars, boats and horses are fun- but they aren’t worth much when it comes time to creating income, and they are expensive to maintain. They don’t add much to your video or your photo, for that matter.
- Keep your long-term money invested for the long term, even in crazy market times, assuming you have an appropriate cushion. Don’t panic at a bad photo.
Your balance sheet may look really good or really bad as a free-standing report- but when you draw it out to its natural conclusion, it can tell a very, very different story. While the photo is a good immediate measure, it’s the future it plays out for you that counts.