How exactly do you track the growth of your net worth over the long run?
The assets of most individual investors are diversified amongst a few stocks or ETFs, some fixed income, a little real estate here and there, a bunch of depreciating assets (from cars to toasters), a retirement plan and perhaps the odd private investment.
It’s easy enough to take a look at your monthly brokerage statement. But I wonder how many people actually track their aggregated net worth, year after year. And more importantly, how do you know if you’re doing well or not? And “well” against what metric?
Typically, we look at total return first, and outperformance second. That means, if you’re a U.S. equities investor, you probably compare your returns to the S&P 500 index. If you’re a more global investor, perhaps the MSCI World index. For your real estate, you likely have a local benchmark price index you can keep and eye on, and you keep tabs on what nearby sales transactions suggest about the valuation of your property.
As for your fixed income portfolio, you might look to JP Morgan’s Global Aggregate Bond Index to get a sense of how your bonds are doing.
But when we put it all together and calculate that total return figure, there’s really only one benchmark that matters over the long run… inflation.
Preserving buying power…
If you think about it, the basic “level-one” objective for wealth management is to first and foremost generate enough return to maintain your standard of living (i.e., and meet the costs associated with that) over time… In other words, keep up with inflation.
If inflation runs at 5 percent, and the annual total return of your net worth is only growing at 3 percent, then despite the positive return, you’re actually just getting poorer.
This gets complicated so let’s recap how we look at inflation.
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Inflation metrics like the Consumer Price Index (CPI) are designed to reflect the changes in prices of all goods and services purchased for consumption by urban households.
Within the “basket” of CPI goods, you’ll see food, energy, consumer items like alcohol and tobacco, medical services, rent, vehicle maintenance and so on.
First complication – I don’t know of a anyone who believes for a moment that their cost of living is only rising at the rate of their nationally published rate of inflation.
In Hong Kong for example, the latest CPI figure for January was a 1.7 percent increase year-on-year. That’s somewhere between laughable and insulting. I know we have some readers living in Hong Kong –if you think your cost of living only rose 1.7 percent in 2017, please tell me.
The biggest expenditure for most people in Hong Kong is rent. Last year, rents for average flats of 700 square foot and less increased by more than 10 percent… and by more than 17 percent if you happen to be looking at a 400 square foot or smaller apartment on Hong Kong island. (If you’re paying for school fees or health insurance, those likewise increased by double-digit percentage gains as well, and nothing in my local supermarket is cheaper than it was last year).
So, if you’re like me, and you feel that inflation numbers appear to be wildly understated, then it doesn’t help much in terms of a benchmark.
Second complication – CPI is a “one size fits all” statistic. The reality is that every individual has completely different personal expenditure profiles – which implies different expense buckets that are growing at completely different rates.
Take U.S. private college tuition fees for example, a significant annual expense for any household that’s facing them. Between the 2016-17 and 2017-18 academic years, fees increased by anywhere from 3 to 5 percent. That may not sound like a lot, but it’s more than twice the rate of inflation, and on an expense that on average sits at nearly US$35,000 a year. In other words, it’s an increase that’s well “above market,” on a very big-ticket expenditure.
Or take healthcare costs in the U.S. Over the past five years, average CPI has been around 1.3 percent. Average healthcare inflation, on the other hand, has been running at more than twice that, at 2.8 percent. That’s a cost likely to make up a larger proportion of expenditure of older people rather than younger households.
It’s a challenge to calculate your own personal level of current and future inflation expectation – and then assess your annual net worth returns in that context.
But if you want to know whether you’re financially standing still, gaining ground, or slipping away… this is a critical place to start.