Tuesday, March 20, 2007

Your Total Measure of Wealth: Income, Personal Savings Rate, and Rate of Return

Author: Nick
Category: Money
Topics: , ,

your total measure of wallet

If you joined us last week, then you know that we’re well on our way to redefining the way people think about wealth. No longer is net worth alone a worthy sign of one’s wealth. Instead, we’re working on a new, more complete calculation for determining one’s wealth status: your Total Measure of Wealth™.

We’ve already reviewed the two easiest parts of your Total Measure of Wealth: age and net worth. Today we’ll cover three more simple components that belong in your wealth measurements.

Income

wish my paycheck were in there

Description

As its name suggests, income is all of the money “incoming” to you before it’s “outgoing” to someone else. Income can come from a variety of sources: your job, investments which increase in value, interest on your savings account, gifts, etc.

We could put together an exhaustive list of every single place from which you earn money, but we’re really only interested in income you can expect to earn for work you perform. Why are we only interested in earned income? Because just about every other source of income is better accounted for by calculations we’ll perform later (like housing status and rate of return).

Your earned income–your salary–is what you make for committing a large chunk of your day to some form of work. Assuming you continue in your same line of work for the foreseeable future, this amount represents the value of your effort. Unlike passive income from things like real estate or investments, you must work continuously in order to maintain your level of earned income.

How to Calculate It

The most common method of comparing earned incomes is by annualizing it, and that’ll work fine for us. Every tax assessment agency in the world probably has a different way of determining your annual earned income, so we’ll need to come up with a standard formula for our purposes. Fortunately that formula will be very simple.

total annual earned income = sum of all annual earned incomes

Before you scream “duh” at your computer screen, we still haven’t done the hard part of this calculation: determining what qualifies as an “earned income.” In order to put together an accurate depiction of your financial status, we’re only going to be interested in income for work you perform which you reasonably expect will continue into the future. You might have made an extra $20,000 last year working weekends as a stripper, but if you’re only pulling in $100 a night these days, you can’t expect to earn another $20,000 this year. And if your salary is $150,000 and you’re expecting a pink slip any day now, your expected salary is now zero until you find another job. But if you’ve been filling out online surveys diligently for a few years now and bring in an extra $50 a month, don’t hesitate to include that as earned income if you plan to continue filling out surveys in coming years.

How to Use This Number

You probably spend a boatload of your time earning this income, so it should have a big influence on how you perceive your wealth. If you compare it to your instantaneous net worth (or, more simply, the amount of money you have in liquid savings), it’ll tell you how important your continued ability to work is to your future livelihood. And if you compare it to the earned incomes of others in your line of work, it’ll also indicate if you’re receiving compensation commensurate with your efforts.

Personal Savings Rate

no, that is an ATM, not a personal savings rate calculator

Description

Your personal savings rate is a measure of how much money you save out of the money you make. A positive personal savings rate means that you get by on the money you make, and you have at least a little bit left over. If you spend every penny you make, then your personal savings rate is zero.

It is also possible to have a negative savings rate. In fact, not only is it possible, but it’s true for the average American. In 2006, the average personal savings rate was negative one percent. That means for every dollar the typical American made, they somehow spent $1.01! How is that possible?

Credit. Loans. Debt. Dipping into existing savings. People are spending money that they’ve already saved without saving new money, and sometimes they’re even spending money they don’t have.

Don’t confuse your personal savings rate with your bank’s savings account interest rate. These are two very different figures, the second of which we’ll take into account later when we examine your rate of return (ROR).

How to Calculate It

Your personal savings rate is easy to calculate. You’ll need two numbers first: your income (see the section above) and your annual savings amount. You can use last year’s figures for both if you like.

How do you determine your annual savings amount? Savings is simply how much of your income you don’t spend. If you have deductions into a retirement fund, this is savings. If you automatically transfer $100 out of every paycheck into a savings account and you don’t spend it, this is savings. The interest you earn on your savings or investments is not savings; these are returns on your investments which we’ll cover later.

You must also factor in negative savings into your savings figure. The biggest sources of negative savings are credit cards you don’t pay off and withdrawals from savings. Subtract any such items from your annual savings amount.

Once you have your income and savings amount figures, just drop them into this equation:

personal savings rate = savings / income

So if you made $100,000 last year and saved $8,000 of it, then your personal savings rate is:

personal savings rate = $8,000 / $100,000 = 0.08 = 8 percent

But say you made $100,000 last year, saved none of it, put $3,000 of purchases on credit cards you didn’t pay off last year, and took $2,000 out of your savings account that you didn’t replace. Your savings rate is:

personal savings rate = ( -$3,000 + -$2,000 ) / $100,000 = -0.05 = -5 percent

How to Use This Number

If your personal savings rate is above zero, congratulations! You’re already well ahead of most Americans. But how far above zero are you? Are you saving 5% of your income every year? How about 10%? The reason I mention 10% is that this is a figure popularly tossed around for how much you should save each year toward retirement. In reality, the percentage you should be saving depends on other factors: your age, your expected life span, your current savings, and many other factors. It might be much higher than 10%, and it probably won’t be much lower.

Visit ChoosetoSave.org for a handy calculator to help you determine your suggested personal savings rate based on your specific situation. Compare your suggested figure to your actual figure in order to panic because you are probably not saving enough.

Suffice it to say that your savings rate should be as high as you can make it. Otherwise, you might have to work every day for the rest of your life. Even Bob Barker doesn’t want to do that, and he’s 83!

Rate of Return (ROR)

invest in barrels

Description

In order to have a rate of return (ROR), you must first have savings or investments. Some examples of these include savings accounts, certificates of deposit (CDs), stocks, retirement funds, and real estate. If you do not have savings or investments, your rate of return is zero; please go sit in the corner for the remainder of this article.

For you cool people with savings or investments, your ROR is simply a measure of how much money your savings and investments are making you. You put money into a CD or a retirement plan and you expect that money to magically grow. There’s nothing magical to the growth–it’s just banks lending your money to other people and giving you a cut of the interest they charge the borrower. But that growth is the basis for your ROR, so let’s compute it now.

How to Calculate It

Your ROR is just another rate of change. It can be positive, negative, or zero. Hopefully it is positive or else you’re picking really bad places to stash your cash.

You may have multiple savings accounts and investments. You can compute your rate of return individually for each one, or you can combine them all and come up with an across-the-board ROR.

To determine your annual ROR for any one investment, use this formula:

annual rate of return = interest earned / amount invested

You might vaguely recognize this formula from grade school. It’s just the familiar simple interest equation solved for the interest rate with a time of one year.

The formula above is only useful for a single year and doesn’t take into account one very powerful factor–compounding interest, or the amount of interest earned on the interest itself. So you may instead wish to use this formula:

annualized rate of return = [(ending value of investment / beginning value) ^ (1 / # of years) ] - 1

For example, let’s say you invested $10,000 in the stock market on January 1, 2005 and rang in New Year 2007 with your investment valued at $14,000. Your annualized rate of return would be:

annualized rate of return = [ ($14,000 / $10,000) ^ (1/2) ] - 1 = 18.3%

You’ll sometimes see the above formula referred to as a compound annual growth rate (CAGR) formula. I think some people just like saying CAGR. Kagger. Kagger. Heh.

Once you apply the formula to all of your investments and savings accounts, you’ll probably notice that they vary. You might have a savings account earning 3%, investments earning 12%, and money in a piggy bank earning 0%. To calculate your overall rate of return across all investments, use this formula:

overall annualized rate of return = [(sum of investment values at end / sum of investment values at start)  ^ (1 / # of years)] - 1

So if you start with $3,000 in savings, $10,000 in stocks, and $200 in a bottle on the nightstand, and you finish with $3,100 in savings, $12,000 in stocks, and $200 in a bottle on the nightstand, your overall rate of return is:

overall annualized rate of return = [ ($3,100 + $12,000 + $200) / ($3,000 + $10,000 + $200) ^ (1/1)] - 1 = 15.9%

How to Use This Number

Your ROR is one of the best health indicators for your savings and investment portfolio. Looking at your ROR by itself isn’t that useful; you need to compare it to other RORs since a “healthy” ROR can change from year to year.

I, like many people, prefer to compare my annual personal rate of return to the S&P 500 index–a listing of 500 large company stocks used to gauge the performance of the stock market in general. Many folks set a goal of “beating the S&P” each year, and they are satisfied with the health of their investments if they do so, even if it’s just by a little.

The final example in How to Calculate It above which showed an overall ROR of 15.9% just squeaked by the 2006 S&P 500 ROR of 15.8%.

There are some years in recent history where you might not want to use the S&P 500 for your comparisons. You may recall the S&P breaking 1500 points in 2000. Thanks to the bursting of the dot-com bubble, it was back below 800 two years later. Lots of people lost a ton of money, but there were plenty of safer investment avenues available to the smart investor (like a savings account earning zero interest, for example!). “Beating the S&P” was not such a hot achievement during these two years, that’s for sure.


With the easy keys to your Total Measure of Wealth out of the way, it’s time to start exploring the new frontier of wealth calculations. Next time, we’ll talk about your job status and how to determine its influence on your financial health.

No comments yet.

Sorry, the comment form is closed at this time.