Where did our wealth come from ? Part two

I sat down recently and tried as best as possible to figure out where we accumulated our wealth over the years. I won’t be posting any absolute numbers here but will talk in percentages, which still tell the basic story. This post will aim to estimate where the wealth was made based on the various buckets of Earning (net of Spending), Saving, Investing. This will be a good start, but I’m also interested to try and draw deeper insights on what really enabled us to achieve FF in accelerated time. That will be the focus of the next post, i.e. to identify what strategies we used to accumulate wealth faster than the average person, and which of these were the most effective.

Now for the hard work of backcasting the past 17 years and analysing where the money came from.

Let’s start at the beginning : As a 20 year old bright-eyed, Uni graduate. I must admit, I was lucky to be able to start from scratch (and not negative). Two things helped me get off to a flying start: 1) I had saved money from part-time work while in Uni to buy my first car with cash and 2) my parents had paid my Uni fees so I had no HECS debt.

So, from this starting point, the task is to make a bridge from – age 20 / 0% to age 38 / 100% net worth.

Despite being a relatively detailed person, I haven’t kept budgets and financial statements that will enable me to forensically calculate this, so we will have to make some simplifying assumptions. Fortunately, I have tended to buy and hold investments, and the majority of investment has been in a handful of residential properties, so I will start by back calculating the capital gain and approx. income derived from these over the years as a percentage of current net worth:

·        Property Capital Gains (after provision for CGT) : +20%

·        Property Net Income (after interest on mortgages) : +6%

I have also been a long-term regular investor in shares, but it has always been a small allocation versus property. Regrettably I don’t have good records of all the capital gains and income from these over the years, but my best estimate of the contribution is :

·        Share/Cash Investment returns (including Superannuation returns)  : +9%

Please note, the above are contributions to net worth from these investments, they are not asset allocations. My actual asset allocations are currently something like 55% Property (too much, I know!), 15% Shares, 10% Super, 20% Cash. The point of this exercise is to identify where the money came from, not where it has been invested.

To recap so far, we have accounted for a third of my net worth being generated from Investing, with 26% from returns on residential property and 9% from returns on shares/cash. Referring back to the FF waterfall (and ignoring the Savings bucket which is included in cash), so the balance two thirds must have come from the surplus of Earnings over Spending. It’s going to be difficult for me to break it down in any more detail except to say :

·        Earning (Salary/wages) less Spending : +65%                ( = 100 – 20 – 6 – 9 %)

I guess this reinforces my position regarding the preferred pathway to FF being to focus on the “Earning less Spending” part of the equation, moreso than the Investing.

The final piece of backcasting is to reconcile our historical after tax Earnings (based on employment contracts, bonuses, tax returns etc) versus the “Earning less Spending” contribution calculated above. Again I don’t have the full records of the past 18 years at my fingertips, so this involves some degree of estimation, but here is the figure I came up with…

·        Earning (Salary/wages) : +80%

·        Implied Spending : -15%                  ( = 65 – 80 %)

I must say that before doing the sums, I was expecting the Earnings to be a much larger multiple of net worth, leaving behind a huge amount of Spending that I would have no idea where all the money went. But this result is a pleasant surprise. So much so in fact that I am questioning the accuracy of my calculations and wondering if I’ve missed a chunk of income somewhere. The inferred “savings rate” is 80% ( = 65 / 80 * 100), which is at the high end based on this poll in the MMM forums:

 

source: http://forum.mrmoneymustache.com/welcome-to-the-forum/what-is-your-savings-rate/?viewresults

In conclusion, having gone through the analysis, it seems the vast majority of net worth came from our Earning (80%), i.e. active income from salary and wages accumulated over the years. Out of this, a relatively small portion was required for Spending (15%) on our basic needs and wants, leaving behind roughly two thirds of the net worth being contributed by “Earning less Spending”. The residual third has been generated from Investing, i.e. passive income and capital gains from property (26%) and shares/cash (9%).

This has been a useful exercise and only deepens my opinion that the key to achieving FF is at the top of the waterfall. Efforts to minimize Spending and maximise Earning will have the biggest impact for most people. Of course it is always beneficial to invest wisely and put your money to work effectively, but the impact is second order in comparison. If you are serious about FF, you need to focus your mind and effort where it will make the most impact. In part three (whenever I eventually get around to writing it !), I will dig deeper into this and try to benchmark the various strategies we used to reach FF.