The most important number

Today’s post is a look at what might be the most important number in personal finance.

The most important number

Everybody you meet has their own idea of which numbers to track.

• It’s the same on the internet – there are quite a few posts on this topic, and they don’t agree on which number(s) to track.

So this post lays out my take – which number rules them all?

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The first thing we need to do is define the problem.

• I will assume that the goal of personal finance is to not run out of money during your lifetime.

A secondary goal along the way is reaching the point at which you don’t need to work in order to live.

• Traditionally this has been called retirement, but we’ll call it financial independence (FI).

We can break this overall journey into three sections:

1. Saving money
2. Investing money
3. Spending money

To begin with, you need to learn to live within your means and save some cash into your pot each month/year.

• You can also focus on earning more each year so that you can save more.

Later on, your pot will reach a size such that its annual fluctuations in size will exceed the amount you can save each year.

• Somewhere around this point, investing well takes over from earning and saving more.

In the third phase, the key thing is to spend within your means again, so that you don’t run out of money.

• Some people will skip phase two and jump straight to phase three as soon as their pot is large enough to support it.

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The point is that the most important number is likely to vary across these three stages.

• We look at each stage in turn and then see if we can come up with a number that ties all of the stage winners together.

So the structure for today is:

• Red herrings – popular numbers that don’t matter that much
• Saving
• Investing
• Spending

Red Herrings

I won’t spend too much time on these:

1. Debts
   • There’s a stage zero on the FI journey before saving, which is paying down your debts.
   • You need to know how much you owe and focus on making this number smaller.
   • You might also want to calculate some ratios, such as debt to income or debt to net worth (gearing).
   • But if you have debts other than a home mortgage, you aren’t yet in the FI game proper.
   • Later on down the road, you might want to add back some leverage to your portfolio, but in the beginning, debt is bad.
2. The interest rate on debt
   • Some people like to track the amount of interest they pay each month, and compare it to their income.
   • But debt is simple – get the lowest rate(s) you can, but more importantly, get rid of your debts as soon as you can.
   • When interest rates are close to zero, paying down debt is less of a priority, but we seem to have just departed that economic regime.
3. The interest rate on savings
   • Cash savings are not there to earn a big return and as your pot increases in size, your allocation to cash will become less significant.
   • Focus on more important things than maximising your savings interest rate.
4. Employer pension match
   • This matters a bit, but it’s beyond your control and for most people, the number will be in a narrow range (say 3% to 6%).
   • Take the free money and move on. (( Obviously, if you work in the UK public sector, the combination of theoretically lower wages and actually higher pension awards might mean that you need to spend a little more time on the details of your workplace pension ))
5. Emergency fund balance
   • It’s good to have an emergency fund of a few months of cash (most people keep three to six months, though as you approach retirement, you might let this grow a little).
   • Once you have the account set up, you can forget about it (and it will become insignificant as your overall pot grows to 30 years or more of expenses).
6. Credit score
   • Historically, this was a US thing, but you see it mentioned all the time here in the UK.
   • My credit score has never made any difference to my finances, and I have no idea what my score is.
   • Its only possible use is for lenders to determine whether to lend money to you, so if you don’t have unsecured lending (ie. your only debt is a mortgage) it has no significance.

The verdict: none of these numbers will have a significant effect on your lifetime financial journey to FI.

• Sort them and move on.

Saving

Things are a little more complicated here.

1. Post-tax income
   • You obviously need to know how much tax is being deducted from your wages, but it’s the relationship between your income and your expenses that counts.
   • You should also focus on increasing your income, especially at the start of your career (where you will have more time to make a difference).
2. Expenses
   • This one is pretty important because (1) it’s half of the equation that determines how much you save and (2) to a certain extent, it’s under your control.
   • You could also subtract your expenses from your net income to work out your cash flow.
3. Savings rate
   • This is the percentage of your income that you are stacking away.
   • There’s a direct relationship between this number and how far away you are from FI. (( Mr Money Mustache kick-started the FIRE movement with his famous post on this topic ))
   • It’s an interesting number, but most people won’t have the wherewithal (high income, or the ability to endure a frugal life) to get this number high enough to make a dramatic difference to their FI Journey.
   • You want your savings rate to be as high as possible, but certainly in double figures in percentage terms.
4. When you start saving
   • Get started as soon as you start earning – compounding over decades is the easy route to a comfortable retirement.
5. Your FI number
   • This is the amount of money you would need to declare financial independence (whether you actually retire or not).
   • Many people ignore this until the investing phase when they are much closer to FI, but I think it is best calculated at the start of your journey.
   • That way you can work backwards from the target to work out how much you need to be saving each year.
   • Once you are on track, it’s not a number that you need to keep a close eye on.
6. Net worth
   • This (total assets minus total liabilities) is useful from year to year to keep track of your progress.
   • But over a lifetime (say 50 years) of investing (and inflation), a single reading won’t tell you too much about where you are on your journey.
   • On the other hand, a rising number from year to year can be motivating.
   • Looking back over 30 years of net worth numbers can be much more revealing.
   • Note that some assets (eg. DB pensions, annuities) provide only an annual income, and this will need to be capitalised into a present value.

The verdict: savings rate is our winner.

• When you are saving, the proportion that you’re saving (assuming your current income and target retirement income are somewhat related) is the best number to track.
• When you start to save comes a close second – if you can get started in your early twenties, you have a much greater chance of success than someone who leaves things until they are in their forties.

Investing

1. Return rate
   • This is the number most people track – how much did I make last year?
   • It’s a misleading number because the strategies with the “best” number for one year are usually the most volatile, and it’s the long-term growth rate (specifically the geometric mean of the annual numbers) that really counts.
2. CAGR
   • This is the number that you should be looking at instead – the growth rate of your net worth over your entire investing journey.
   • The funny thing about CAGR is that a relatively small number leads to every big one over time.
   • Many private investors target gains of 20% pa or more, but these have only been reliably achieved by very few of the best investors.
   • A CAGR of 8% or 10% will make you rich eventually.
3. Asset allocation
   • I’m cheating a bit here since asset allocation is not a single number, but it is the largest single determinant of your final net worth.
   • We can simplify even further by focusing on the ratio of risk assets to stability assets – 75% risk assets is usually best over the long term, but not many people have the stomach for this, and they may have constraints (property, DB pensions) which limit the amount that can be directly allocated to risk assets.
4. Costs
   • Returns across all investors average out to market returns minus costs, so the lower your costs, the closer you should get to market returns (the higher your returns should be).
   • And unlike returns, costs are (to a certain extent) under your control.
   • So avoid expensive active funds and full-service brokers – use low-coat accounts and structure your ideal asset allocation using cheap passive funds as far as possible.
5. Taxes
   • Taxes are a specialised form of costs, and in the UK at least, the tax regime is relatively benign for investors.
   • The two main tax shelters are pensions (SIPPs) and ISAs but don’t forget your primary residence.
   • Beyond that, you have EIS and VCT, and a £12K annual allowance for capital gains.
   • So the capacity is there – the key is consistency, and making sure that you get as close as possible to using up your allowances each year.
6. Years to FI
   • To calculate this, you’re going to need to make some assumptions:
     • A future savings rate
     • A real growth rate for your investments
     • A future level of spending (in cash terms)
     • A multiplier for how many years of spending your pot will need to hold before you feel able to quit (25 to 33 is the usual range).
   • Years to go is best calculated when you are some distance into your FI journey – if the answer is more than 10 years you might well find it demoralising, whereas if the answer is less than five you might find it motivating.
7. Lifetime Wealth Ratio (LWR)
   • This was invented by J Money from the Budgets are Sexy blog and compares your net worth to your total lifetime income.
   • I have been tracking this number (using gross income) without knowing what it was called, but haven’t found it to be massively useful in terms of managing your money.
   • A high ratio does indicate some kind of long-term financial competence (how good you are at converting the flow of income into the stock of wealth), and there is a feeling of satisfaction when the ratio passes one (you have more money than you have ever earned) – but that’s about it.
   • If it ever became important to compare your financial progress with others who have had different incomes, this might be the number to use.
   • Even then, you would need to be of similar ages, since LWR tend to rise with age as compounding kicks in.
   • There’s also a bias against very high earners who pay higher taxes (and those in general who neglect tax planning).
   • Nick Maguilli (OfDollarsAndData) has a modified version called the Wealth Discipline Ratio (WDR) which removes “necessity spending” (which could never be saved) from the income side of the equation.

The verdict: it’s tempting to go with CAGR, but your asset allocation is the decision which is under control that will lead to the best CAGR.

Spending

There are a few obvious contenders in this section:

1. Expenses (again)
   • You should have worked out how much you will need to spend each year long before you reach the spending stage, but it’s a key input into whether you will be successful in this phase.
2. Costs and taxes (again)
   • These are just as important in decumulation as in accumulation.
3. Safe Withdrawal Rate (SWR)
   • This is the amount that you think you can take out of your portfolio each year, without running out of money in the end.
   • It’s usually defined with reference to a fixed timescale, a target percentage success rate and a terminal pot value (to be used for bequests on your death).
   • The rate you choose will influence your asset
   • The most famous SWR is the 4% rule, which says that (in the US, in the past) you can take 4% of your pot to live on, with a 95% chance of not running out over 30 years (and no terminal pot guaranteed).
   • 30 years won’t be long enough for early retirees, and you should at least make sure that your time horizon comfortably exceeds your life expectancy.
   • I’m also not comfortable with a 5% failure rate, which brings us to:
4. Perpetual Withdrawal Rate (PWR, also known as the Failsafe Withdrawal Rate).
   • This is an amount that you can take out of your pot without running out of money over any conceivable timescale.
   • The maximum PWR works out to be around 3.3% pa, though of course most people withdrawing this little won’t come close to running out of money, and indeed will end up with much more money than they started with.
   • The top PWR depends on an asset allocation something like 75% stocks, 25% defensive assets (bonds) and 5% alternatives (gold etc).
   • If you can’t reach that allocation (or are uncomfortable with it) you’ll have to settle for a lower PWR (2% or 3% pa).
5. Death Ratio
   • This is your pot size divided by your annual expenses, to give the number of years of expenses that you hold, divided again by your life expectancy, to give the multiple by which you exceed the amount of money you should need before your death.
   • This number is more interesting if you track it from year to year, and note whether it is rising or falling.

The verdict: PWR is the winner here.

Synthesis

It looks as though we have a different number for each stage of the FI journey.

• But they can be linked together through the number that they each affect – net worth.

In saving, we are trying to boost our pot size (and achieve a high net worth CAGR).

• Investing is the same, but the control knob is asset allocation rather than savings rate.

And in decumulation (spending) our goal is to keep our “net” CAGR (gains minus expenses) above zero so that we don’t run out of money too soon.

• So if we were forced to settle on a single number for life, the most useful is the net worth CAGR.

Conclusions

That’s it for today – Net Worth CAGR is the overall winner.

• Lots of people will choose a different number to watch, depending on which stage of the FI race they are involved in.

And some people will need to watch several numbers to know everything is on track.

I’ll be back soon with a follow-up post where I look at my own values for the numbers we’ve covered, and see whether analysing my own journey to FI leads to different conclusions.

• Until next time.