This is a brief revisit of some basics of personal finance. Consider this cash flow paradigm: Income, less taxes, less consumption equals investment. A different statement of the formula is that money from income can only go one of three places: taxes, consumption, or savings / investment. This is not higher math. It is arithmetic. Let’s examine the elements of the formula.
Income is different from cash flow. Cash flow may be from income, from withdrawal or from savings. So, for example, pension and social security, along with wages, and net business income, are all "income". Note that IRA withdrawals are not really "income" but withdrawals from savings, despite clearly being included in "taxable income". In that sense, IRA withdrawals are simply cash flow.
The confusion between "income" and "cash flow" can be the source of a fair amount of misalignment of risk and return tradeoffs in the structuring of investment portfolios. Think of income as that which increases your net worth.
Taxes are largely objective and deterministic. Higher income means higher taxes. Your taxes follow how you order your affairs, and while some tax advantages may be achieved by thoughtful structuring of your affairs, your tax liability is pretty much set for each year by what happens between January 1 and December 31 of that year.
We place a good deal of emphasis on helping our clients manage their tax exposure. In most cases this consists of deferral of taxes to future years, and in a few circumstances can consist of elimination of some taxes (think Roth IRA and charitable contributions of appreciated assets). Tax planning and tax exposure management are valuable, and we believe essential to the financial planning process.
Consumption for purposes of this formula includes any outlay where the benefit is short-lived. It may be groceries, rent, gasoline, utilities, childcare, elder care, etc. Other expenses with benefits that are not short-lived, such as education, medical care, gifts, charitable contributions, are still rightly considered consumption.
Savings and Investment, for these purposes, are one and the same. Savings is the difference between resources produced and resources either consumed or given up in taxes. The essence of savings is undoubtedly pre-historic. In the stone age, any food or seed kept aside for future use/consumption was savings. Any reasonably prudent cave dweller in those times would have wanted to produce more than needed for current consumption so it would be possible to survive lean times. It's the same now. Savings accumulated while times are prosperous give us security to live through lean times (whether the lean times are temporary unemployment, retirement, or something in between). Anyone who consumes all of (or more than) the amount they can produce, without preparing well in advance for that circumstance, will find themselves wholly dependent on others and subject to their whim. The "others" may be simple personal charity or may be some manifestation of social welfare.
The sameness of savings and investment applies even to a wad of bills in the mattress. In the current world, money saved resides in a financial account, be it checking, savings, or a brokerage or retirement account. It can also reside in hard assets like real estate, including personal residence or rental property, or (as mentioned above) an automobile or other personal property.
While it may seem that amounts held in checking or savings account are not invested, those amounts fulfill a purpose or need for the saver. Secondly, those amounts at a bank or other financial institution support the ability of that institution to either make loans to others or to simply buy fixed income securities such as Certificates of Deposit or bonds. In every case, from checking and savings at one end of the spectrum, to high-risk venture capital vehicles, the resource is available to the capital market to support productive use. So, there is no point on the risk spectrum at which one can reasonably say the money is not invested. It is always invested if it is not spent. It may be invested in low yield, low return, low risk vehicles, but it is still invested.
The basics of management personal finances are simple:
- More income with the same consumption means more investment.
- Less consumption with the same income means more investment.
- Consumption greater than income less taxes means negative investment (disinvestment i.e. withdrawal). This condition may be appropriate and suitable for a retiree but may be disastrous for a your person who should be saving.
- It is impossible to have a productive economy without savings and investment.
- It is impossible for a family to have financial security without savings and investment.
- To increase investment, one must do at least one of three things: increase income, reduce taxes, reduce consumption.
In considering cash flow for purposes of financial planning, we find that the issue of consumption is the critical factor, the fulcrum. The ability to manage one’s spending and consumption is far and away the most useful key to achieving financial security.
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The table below shows the returns through September 30, 2021, for selected investment asset classes. In most cases, the results below are appropriate benchmarks for the related mutual funds in your investment portfolio.