Wealth: Creating A Roadmap To Get There (Chapter 5)*

A road map to wealth is a timeline of dollars expected along the way and this chapter explains how to do so. Words: 1593

Before reading the following please read (here) the Preface and Overview of the book WEALTH IF YOU WANT IT on wealth creation by “Monty Pelerin” (a pseudonym) of EconomicNoise.com.

To create this roadmap, you must accomplish the following three things:

1. determine your current location,
2. define your preferred destination, and
3. plot a route that gets from one to the other.

You already accomplished the first aim. That was your net worth. You used the last few years of income and spending to determine where you would end up (your drifting boat destination). This destination is unsatisfactory for most. If unsatisfactory for you, it is time to take charge of your boat. This chapter explains how to do so.

CHANGING THE DESTINATION

Changing your destination requires behavioral changes now and in the future. Determine a new destination. Then make the changes necessary to get there.

Determining a reasonable destination is harder than it might seem. For individuals, a “chicken and egg” problem exists. To understand, a contrast of corporate planning with individual planning is useful. Each has the same purpose but requires a different approach.

CORPORATE PLANNING

Long-term planning takes precedence over short-term planning in the corporate world. A manager sets his long-term goal first. Then he develops a series of short-term goals and plans that will, if met, achieve the long-term goal.

Corporations are not dependent solely on internally generated funds for expansion or growth purposes. Establishing a goal beyond a corporation’s capacity to fund internally is routine.

Capital markets make it possible for corporations to plan in this manner as long as capital markets believe in the goal and the company, external funds are available. Part of the corporate planning process is determining how much new capital is necessary, when needed, and the proper mix of debt and equity appropriate.

INDIVIDUAL PLANNING

Individuals have limited access to funding. Consumer credit or borrowing against secured assets (a mortgage to buy a home) are possible resources. These are not for wealth-generating purposes (although the home might provide appreciation).

The individual cannot sell shares in himself. Therefore, he has no access to capital markets. His funds come only from savings. This circumstance makes the planning effort more difficult. He cannot set a long-term goal independent of short-term outcomes. The long-term wealth of an individual depends on the short-term savings he generates and what they earn along the way.

QUANDARY

How do you establish a short-term plan consistent with a long-term plan if the long-term plan depends on the short-term plan? The problem is that the short and long terms interact.

A proper solution requires a trial-and-error approach. Literally, the chicken-egg problem exists for both.

Assume the chicken is the income producer, and the eggs produced represent income. Both the corporation and the individual prefer more income to less.

Corporations determine how many “eggs” they want in the future and then coordinate the purchase of chickens along the way to achieve that goal. Capital markets allow them to do so if they evidence creditworthiness.

Individuals have a chicken or two that produces eggs. Individuals also want a lot of eggs at retirement and prefer a reasonable standard of living today. The more eggs consumed, the higher the current standard of living but, the higher the standard of living, the fewer eggs left to hatch into chickens. This conflict represents the tradeoff between spending and saving.

For any level of egg production, you decide whether you want a higher standard of living today (eat more eggs) or a higher one tomorrow (hatch more chickens). Consuming fewer eggs provides more chickens for future egg production.

This interaction between income and savings complicates the determination of a wealth goal.

LONG-TERM BUDGET

In the prior chapter, you developed a passive estimate for terminal wealth and then extended current income and spending habits forward by compounding them into terminal wealth.

This passive approach now must become an activist one. We shift from forecasting (simple predicting) to planning (altering outcomes).

ACTIVIST ONE-YEAR PLAN

The passive budget, developed in the last chapter, is your starting point. It provides a forecast. Now you must turn this forecast into a plan.

You summarized every expenditure and income item for the last two or three years and then forecast where that behavior, if continued, would take you. Now we intervene and plan. This implies changing behavior.

Start with the information collected in the last chapter. We must classify each expenditure into one of three categories:

1. “WANTS”
2. “NEEDS”
3. “NOT SURE.”

Use these definitions to assist in your classifications:
• “Wants” are nice to have, but not truly necessary.
• “Needs” are absolutely necessary.
• “Not Sure” is a holding category to be resolved later. Anything that you cannot decide upon in the first run goes into “Not Sure.”

THE AIM

This exercise is your first attempt at changing things. It is the beginning of turning a forecast into a plan. Your spending/savings habits today define your retirement tomorrow.

Classifying spending into categories is difficult. It requires serious introspection. You determine who you are versus who you want people to think you are. As you go through the process, self-criticism, guilt, disappointment, and embarrassment are not uncommon.

In short, the task is not pleasant, but it is necessary. Your reactions are normal. In effect, you are re-defining yourself, at least regarding financial discipline and responsibility. The review will produce instances of pride and disappointment…

TAKE A BREAK

Upon completion, every dollar will appear in one of three columns: Needs, Wants and Not Sure. A break is appropriate. Two weeks seems appropriate. During this break, try to forget about everything you went through. It has likely been psychologically tough and draining. The break is necessary to refresh. It is also important because it provides a more balanced perspective when you return.

BACK FROM BREAK

Finally, it is time to review your classifications. This step will be easier. Deal only with the items in your “Not Sure” column. Move each item there to the “Want” or “Need” column.

Upon completion, put your work aside for a few days. Then return to it. You have two columns of figures. One represents Wants and the other Needs. Review each item to confirm its placement. Change classifications if necessary.

Add up the dollar amounts of both columns. Be sure that each number represents only one year of spending! (That should be if you averaged the historical figures as recommended.)

For the timid, savings likely improved from the first pass. The aggressive likely showed a decline in savings. Both results are fine! Reasonableness and realism is the goal. Your aim is to increase savings realistically.

WHAT HAVE YOU DONE?

In effect, you have created a basic budget for next year. The total from the Need column represents your best estimate of what you need to spend. The total from the Want column represents increased savings (or reduced dis-savings) than in the past. All changes reflect your intention to change spending habits.

NEW RESULTS

Now, refer to the original savings calculated in Chapter 4. The total from the newly constructed Want column shows planned reductions in spending. This amount, added to your previous savings amount from Chapter 4, provides you with your new expected savings.

You just adjusted your historical behavior into your projected behavior. You created a one-year budget reflecting your new intended life-style.

Hopefully, you now have positive savings. If so, repeat the calculation done in Chapter 4 with the new numbers to determine a new terminal wealth estimate.

LONG-TERM BUDGET CREATED FROM ACTIVIST BUDGET

Your new annual savings amount is hopefully more realistic than your first attempt. It allowed you to calculate a new terminal wealth estimate. Presumably, your boat is on a better course.

CHANGING THE FUTURE
All work done used historical data. Now we look at the future. The further out we go, the hazier our vision becomes. However, we likely have reasonable confidence regarding the next few years.

Each individual is unique. The generic example below shows the mechanics of the process. )These remain the same regardless of what numbers you use for your particular situation.)

• Your IRA account is worth $20,000 today.
• Savings is $1,500 per year currently.
• An expected promotion in three years will allow you to raise savings by $2,000 per year.
• Six years from now, you expect another promotion that will increase potential savings by another $2,000 per year.

Use the above to calculate terminal wealth thirty years from today.

These elements introduce some complexity into the calculation. However, the problem is more realistic than prior examples. Unfortunately, this complexity makes it unreasonable and/or incorrect to use prior models.

FUTURE VALUE OF UNEQUAL CASH FLOWS

This fresh problem involves a stream of unequal cash flows. The annuity model no longer applies.

I found no suitable model on line (although you might have better luck). The required model must be able to deal with uneven cash flows. I created a crude spreadsheet for this problem. (Bruce Konnors provides a YouTube video regarding how to develop such a spreadsheet.)

To continue reading this chapter and the rest of the book please go here and scroll down to page 67.

The above post is a slightly edited (…) partial version of Chapter 5 from a book entitled Wealth If You Want It by “Monty Pelerin” (a pseudonym) of EconomicNoise.com.

Pelerin has a doctorate degree in Finance from Syracuse University, an MBA from the University of Chicago and an undergraduate degree in economics from Duke University. He can be reached at [email protected] if you have any questions (put HELP in the subject line to attract my attention). Permission is granted to copy this post for non-commercial purposes with proper attribution.

Additional Contents of WEALTH IF YOU WANT IT

1. “Wealth If You Want It” & How To Get It: An Introduction

5. Wealth: Where Are YOU Headed? (Chapter 4)*