This week we’re going to look at 6 core personal finance concepts. These are concepts that it’s easy for those of us working in the space to assume everyone understands. It might also be that your understanding of what these terms means differs from industry definition. So let’s run through these core concepts together and make sure we’re all on the same page.
1. Savings Capacity
One of the key things we will seek to clarify in an initial meeting with a prospective new client is what is their savings capacity. The savings capacity is the enabler of wealth creation. It’s the bricks that enable you to build the house.
Your savings capacity is the difference between how much you earn each month after tax, and how much you spend.
When ascertaining our savings capacity we first need to be clear on our spending. Whilst some costs like groceries are pretty stable month to month, other expenses vary depending on bills, holidays, gifts, etc, which can make it difficult to nail down a reliable savings capacity that we can use to build wealth.
We can solve for this variability in two ways. First, adopt a cash flow strategy such as the bucket approach, to smooth out the cost of your bills and holidays. You can find details on these strategies in my Financial Autonomy book. The second thing to do is to build in some buffers. Firstly, don’t have your living account going down to zero each month. Depending on your circumstances it might be that you try and keep it above a few thousand dollars. Then also in your cash flow plan, when estimating your regular monthly expenses, round up wherever possible. These two approaches just give a bit of a cushion. No one wants to live in a financial straitjacket.
Accurately estimating your savings capacity does get a bit trickier where your income is variable, for instance if you work on a commission basis, or are self-employed. Hopefully you can have some sort of base level of income that you can confidently forecast as a starting point, and perhaps your savings capacity becomes something like $1,300 a month plus 60% of each quarters bonus.
2. Emergency Fund
An emergency fund is certainly a core personal finance concept. Life inevitably throws us curveballs. The fridge breaks down, you get made redundant, you need to visit a sick relative overseas at short notice, or your child gets sick. It’s very often these unexpected expenses that get people into a downward financial spiral. Without an emergency fund they inevitably need to borrow, typically via credit card, to meet these expenses, and then they are constantly struggling to get their head back above water.
An emergency fund is a pool of money that you set aside, which can be easily accessed in the event of an unexpected expense. The amount you should hold in an emergency fund is not set in stone, but as a guide most people work to between three and six months of after-tax income.
3. Compounding
Compounding is a mathematical concept that is fundamental to accumulating wealth and achieving financial independence. If you invested $1,000 and it earned 10%, then after one year you would have $1,100, $100 of new money representing the earnings on your capital.
Provided you left those earnings in the investment and it once again earned 10% in year 2, your $1100 would grow to $1210. Notice that in year one your earnings were $100 but in year 2 they were $110. The earnings are more in the second year because you’re making a return not just on your initial amount invested, but also on what you earned in year one. Continue this process in year 3, 4, 5, etc every year earning money on prior year earnings. At a 10% return, after eight years the value of your investment will have doubled. Your $1,000 is now $2,000, with no effort from you other than the restraint to leave it alone and let it grow. Roll forward another eight years and your $2,000 becomes $4,000, go again and you’re at $8,000.
You’ve probably heard of Warren Buffett, considered one of the most successful investors of our time. A key reason he has become one of the wealthiest people in the world is that he started investing young and has survived into his 90s. Lots of time for his investments to double and double again. Lots of compounding.
Compounding then is earning a return on previous earnings. Earning interest on your interest if you like.
4. Active Management vs Indexing
When it comes to investment funds, such as those used in your superannuation account, managed fund, or an exchange traded fund, there are two approaches that can be followed. Active Management or Indexing.
Historically, Active Management has been the dominant approach. Active Management entails humans using their brains, conducting research, and deciding which investments to purchase based on their conclusions.
Indexing strips out all this thinking, and simply replicates a market. So an index of the Australian share market would probably replicate the ASX200 index. This means that if BHP was 11% of the ASX200 index, then an index fund of Australian shares would hold 11% of its portfolio in BHP. It undertakes no research, and has no view as to whether BHP is attractively priced, has good prospects for the future, or has competent management. An index fund assumes that all that information is already reflected in the price of the share, due to the activities of the active investors.
Most of us would like to think that Active Management will produce the best returns. Surely researching and thinking about which investments make sense and which don’t has to produce a result. But the important thing to appreciate is that whenever you buy, someone else is selling and vice versa. You might have concluded that company XYZ is a great buy, but quite clearly someone out there has the opposite view. And you can’t both be right.
The question then becomes who is right more often. It’s not necessary for you to be right all the time as an active investor, just at least 51% of the time. And certainly there are some active investors that can achieve this success rate. But for those winners there must be losers on the other side, and for regular investors like you and I, with more to do than just stare at the stock market, chances are we will end up on the losers side of the ledger.
It’s for this reason that countless studies have shown that the most successful way for individuals to invest their wealth is through the predominant use of index type investments.
Now that doesn’t mean that investing requires us to do nothing. There is still value in determining how much to allocate to different asset classes, shares versus bonds for instance. And there is research to show that active management can tend to deliver value in certain sectors, most particularly in the small cap sector where the reward for thorough research is greater. You might also like active investment where you want the portfolio to reflect a particular ethical concern, for instance a desire to invest in a way that positively contributes to the energy transition currently underway.
Suffice to say, it’s not as simple as Indexing good, Active Management bad. But appreciating the difference between the two is certainly a core personal finance concept worth having a grasp of.
5. Gearing
Gearing. Borrowing to invest. Most people who successfully build wealth have some form of gearing within their strategy. Most of us will borrow to buy our home, and in recent history, most homeowners with a 10 year plus timeframe will have seen their property value rise, resulting in their equity, that is to say the portion of the asset that belongs to them, growing considerably. Rising home equity then provides the opportunity to build more wealth and financial security.
Gearing magnifies an outcome. It’s certainly far from assured that gearing will deliver a positive result for you. It magnifies outcomes in both positive and negative directions. To be successful then, you need to go into an asset that grows in value over time. That over time piece is the crucial factor. Whether it be shares or property, the change in value in a single year is fairly random. But over a 10 years, we can have a high level of confidence in seeing growth.
When borrowing rates were two or three percent, engineering a gearing strategy to produce a positive return was not especially challenging. Today the world has changed, with borrowing costs double that of a few years back. Further rate rises are expected. Gearing strategies at this moment in time need to be very carefully considered.
6. Accumulation Phase vs Pension Phase
The final of my core personal finance concepts is an appreciation for the Accumulation phase versus the Pension phase. Here I’m referring to superannuation. We all get superannuation accounts thrust upon us when we start work. As anyone listening to this podcast I’m sure would know, the superannuation accounts purpose is to support us when we retire.
If you are still in the working phase of your life, you are in the accumulation phase. As I’m sure you can grasp from the name, this is the period when money is going into your superannuation account, accumulating, making the most of compounding, to provide you with a nest egg.
Perhaps what you might not have given a lot of thought to though is what actually happens to your super when you retire. The answer is, the Pension phase of superannuation. Here your Super fund shifts into reverse gear. Rather than money being added to it all the time, instead it starts paying out to you, usually on a monthly basis.
The accumulation and pension phases of superannuation are different on a number of levels beyond the most obvious cash flow ones. Firstly, whilst in the accumulation phase you are unable to access your savings. The technical term used is that they are “preserved”. That means you can’t access them until you are at least 60 years of age.
But that changes entirely once you are in pension phase. Whilst the primary purpose of the pension phase is to generate regular income for you, once in this phase your capital becomes entirely accessible. Imagine for instance that perhaps as a consequence of a marriage breakdown, you end up reaching retirement age and still have some money owing on your mortgage. Once in pension phase you could potentially withdraw a lump sum out of your superannuation to pay this debt off.
Another important difference is the tax treatment. Whilst in accumulation phase all income is taxed at 15%, gains at 10%. Once you move to pension phase however, the tax rate becomes zero on both income and capital gains. The government is currently talking about making some changes to these rules, but they are only for people with very large balances and so are unlikely to affect any of us.
Well, that’s it for my 6 core personal finance concepts:
- Savings Capacity
- Emergency Fund
- Compounding
- Active Management vs Indexing
- Gearing
- Accumulation Phase vs Pension Phase
Hopefully there’s been a few nuggets in here to help you achieve Financial Autonomy and gain the choice in life that you deserve.
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