First LIVE show aired last night … thanks to all of those who joined us (!) … a few technical glitches … the host wasn’t exactly Jay Leno [I don't have as many cars as Jay, either] … some great question and fantastic chatting. Same time next week, all?
Now, for today’s post …
Today, I am reviewing – and adding to – an important concept recently introduced by mymoneyblog … a way of comparing wealth without resorting to meaningless concepts like Net Worth.
It’s a ratio that mymoneyblog has dubbed the Financial Freedom Ratio:
If someone tells you that they have a net worth of $1,000,000, you might be impressed. But what if they spent $150,000 per year? If they stopped working, the money wouldn’t last very long. However, if they only spent $15,000 per year, they might already be set for life. In other words, your income doesn’t matter. Your expenses do. It may be assumed that the two are related, but that is not necessarily true. We all have the power to disconnect the two.
I’m sure somebody somewhere has already coined this term, but until told otherwise I will call it the Financial Freedom Ratio (FFR):
By liquid, I simply mean you can sell it for cash while not affecting your expenses. (Don’t count your car if you need it for work).
I like the FFR because it is a way to compare two people who may be on different financial paths; I mean, who is better off?
The doctor who earns $250k per year (net) but spends $260k a year on mortgages, cars, vacations?
The veterinarian who earns $150k per year (net) but spends $110K and has paid off their house?
But, there is a problem, as mymoneyblog also points out:
For example, if you had $200,000 but only spent $20,000 per year you would have the FFR value of 10 as someone with $1,000,000 but spent $100,000 per year. This also calls into focus how important spending patterns are when talking about financial freedom.
You see, Ratios are dimensionless … they lose scale. Therefore, with the FFR a ‘hobo’ COULD conceivably have a better FFR than a multimillionaire!
For example: my FFR is 40 (purely based upon cash in the bank) – but, that doesn’t mean anything to you, until I also tell you one of the Scaling Numbers (either ‘liquid net worth’ OR ‘annual spending’ will do).
If we want to keep these numbers secret (the great benefit of the FFR), then we simply need to add some sort of Quality of Life Index:
As long as the QLI is greater than 1, then I agree that the FFR is a great way to share ‘financial positions’ WITHOUT disclosing how much we actually have in the bank!
It is also a great way to determine if your are on track to your ideal retirement, rather than just settling for the personal finance blogger’s curse: you will save, and save, and save until you can retire on your current paltry salary …
… the QLI forces you to assess what you really need to be able to spend in retirement and then it, together with the FFR, doesn’t let you retire until you can get there!
The only problem?
It doesn’t tell you how to do it! So, you tell me … how will you do it???