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Buying financial freedom

Once a month I do a lap around my bank and brokerage accounts, manually downloading transaction statements and populating my desktop based personal finance software.

20+ years of experience helping clients to implement evidence-based decision making has taught me that a person’s ability to lie to themselves is boundless. Therefore I don’t place much value on budgeting, as without diligent execution a budget is an empty promise of hopes and dreams on the road to disappointment.

“a budget is an empty promise of hopes and dreams on the road to disappointment”

I do find keeping score of what actually happened is instructive.  This allows analysis of the facts. Credit card statements don’t lie.

My setup is simple.

Expenses

Outflows fall into one of five categories:

  • Needs
  • Housing
  • Investment Expenses
  • Tax
  • Wants
Snob Hill or Struggle Town

Snob Hill or Struggle Town? Housing size, location and price is a choice. Image credit: Namirob and pix027.

Needs covers the essentials, like groceries. Regardless of whether you reside on Snob Hill or in Struggle Town, there isn’t a huge variance in the cost of needs within a given locale.

Housing has its own category because for many people (me included) housing is their second biggest outflow after tax. Having a safe, warm, dry place to sleep at night is definitely a need… yet the location, size, and the price that we pay for that home is a discretionary choice.

Investment Expenses are those costs incurred while generating the income streams I did not need to be physically present to earn.

Tax is a, largely discretionary, expense that should be managed like any other. It is also the biggest outflow for many people. If it isn’t then you either need to invest more in yourself because you aren’t earning what you could be… or you deserve credit for managing your finances effectively.

Wants covers everything else: gifts, furnishings, holidays, mobile phone bills, eating out, and charitable donations.

Income

Inflows are split into two categories:

  • Income that requires my physical presence to earn

and

  • Income that does not.

Passive and active income are myths

Being a generally disagreeable fellow, I take issue with both the terms active and passive income.

There are times when investment properties can feel anything but passive, during maintenance issues or when refinancing for example.

Conversely, I have some clients who feel reassured enough by my presence that they pay me a retainer, even though they seldom call upon it.

Keeping score

Providing your combined inflows exceed your combined outflows then any combination can be considered winning.

If that isn’t the case for you then you are doing it wrong!

My definition of financial freedom is when the inflows not requiring my physical presence reliably covered the outflows. I comfortably passed this milestone before my 40th birthday.

What does “normal” look like?

I was curious what a “normal” expense split looked like. Which in turn led me to wonder what a “normal” income split would look like.

If I don’t know something I’m a big fan of asking somebody who does, so I asked the Office of National Statistics. They pointed out “normal” is subjectively based on perspective, but they could tell me what the “average” person did.

They had a fair point. Everyone thinks of themselves as being above average, yet enough people take out payday loans and watch reality television to make both compelling business models.

An “average” person does…

The first chart breaks down the weekly outgoings of the average London household.

Weekly household expenditure by category - London 2017

Weekly household expenditure by category – London 2017

It is alarming how little people save, particularly given the climate of low interest rates, low inflation, and full employment.

The second chart aggregates that spending into my five categories.

Weekly household expenditure by category grouping - London 2017

Weekly household expenditure by category grouping – London 2017

Housing and tax collectively account for almost half of gross earnings. Wants consumes nearly a third.

The third chart plots average UK inflows against average London outflows. Unfortunately, the ONS didn’t ask the right questions to allow the income side of things to be broken down by region.

Weekly household UK income and London expenditure by category - 2017

Weekly household UK income and London expenditure by category – 2017

The good news is the average person earns marginally more than they spend.

The bad news is that the curse of averages makes the inflow figures a bit of a nonsense. How many wage earners do you know who also earn self-employment income, private pension income, and government benefits?

Buying financial freedom

I found it helpful and motivating to set out my own expenditures in this manner.

It allowed me to plot business, dividend, interest and rental income alongside my household expenditures.

As those income streams grew I could chart my progress by doing the victory dance each time those income streams sustainably covered off another expenditure category.

It was a good feeling knowing I never again needed to worry about how I would pay the gas bill, or where the grocery money would come from.

In time all my bills were covered.

Eventually all my wants were similarly funded, buying financial freedom.

After that any additional earnings were icing on the cake… and there aren’t too many problems that can’t be solved with cake.

Next Steps

  • How do your expenditure and income breakdowns compare to the “average“?
  • If you liked this post then please share it with your friends.
Disclaimer: I may receive a (very) small commission from any purchase you make via links on this website.
You have to live somewhere

After moving house 13 times in the last 20 years, this is what I know:

  • Moving sucks, and is expensive.
  • Clutter multiplies when we aren’t looking.
  • Stuff will break and get lost in transit.
  • Furniture that looked great in your old house likely won’t even fit in the new one.
  • Establishing internet connectivity is never as quick or seamless as the suppliers promise.

I will confess to once purchasing a property I was renting at the time, mostly to avoid moving!

Throughout that period, I have owned a portfolio of well-located investment properties. However the majority of the time I have chosen to rent where I lived. Renting provided a nicer standard of accommodation, with a shorter commute, than the equivalent mortgage payment could support.

I recently caught myself falling into the trap of unquestionably accepting that today reflects how they will always be. Some things don’t change, but these all do!

Negligible interest rates?

Low inflation?

Full employment?

Ever-rising property prices?

Booming stock market?

My being young, slim, able to run a sub-20 minute 5km… oh wait, that was a flashback to the days before I got old and started wearing my beer. Perhaps some things actually do change!

Being a cantankerous individual who usually challenges everything, this blind acceptance alarmed me. I decided to recalibrate what I considered “normal” by researching longer-term trends.

This exercise also caused me to challenge some of my own long-held beliefs. One of those was whether it really does make more sense to rent rather than own where I live?

Is it cheaper to buy or rent?

The first chart plots the current monthly buy versus rent cash flow position. Data sourced from Zoopla’s current average rental and purchase prices for my postcode, and a typical tracker mortgage from MoneySavingExpert’s comparison tables.

Monthly cashflow by property ownership option

Monthly cashflow by property ownership option

Conclusion: Today owning costs more than renting… in my postcode area.

End of discussion, right?

Isn’t rent supposed to be “dead money“?

Wait a second… isn’t renting “dead money”? Once the mortgage is paid off I would own a house!

This point requires an examination of opportunity cost. I could have paid the mortgage every month, or I could have paid the rent and invested any difference in the stock market.

Nobody knows what the future will hold, so instead let’s travel back in time the duration of a typical 25-year variable rate mortgage to evaluate what the outcomes would have been.

The life of a mortgage in pictures

This chart displays the composition of payments over the life of the mortgage. The recent period of record low-interest rates makes for an interesting picture.

Payment composition over the life of a 25 year mortgage

Payment composition over the life of a 25 year mortgage

Conclusion: Since the financial crisis mortgages have been almost “free”. Doh!

Next, we have the cumulative loan principal and interest over the duration of the mortgage. Owning occupying a property avoids spending on rent, though mortgage interest is still a considerable expense.

Cost of using a mortgage to purchase a property

Cost of using a mortgage to purchase a property

Conclusion: Over the duration of a mortgage the interest component certainly adds up.

This chart is an interesting one. When you purchase an asset you retain any capital growth it experiences. My postcode area has experienced a CAGR rate of 9.41% over the last 25 years, although the actual investment ride has been bumpier than the CAGR makes it sound.

Property equity accumulation breakdown over 25 year mortgage term

Property equity accumulation breakdown over 25 year mortgage term

Conclusion: By missing the property appreciation gravy train, renters like myself potentially left a lot of money on the table.

Renting is cheaper today, but will that always be so?

With the development of the homeowner equity position understood, we can compare the rent versus buy outcome.

25 years ago renting cost less than buying, just as it does today. That situation soon reversed, as rental prices increased over time.

Rents versus mortgage payments over the 25 year mortgage term

Rents versus mortgage payments over the 25 year mortgage term

Conclusion: Mortgage payments are anchored by the property purchase price. Property prices and rents both fluctuate in response to supply and demand.

The stock market must have outperformed property?

What would have happened if I had invested the surplus between rent and mortgage payments while it was cheaper to rent? The following chart displays the outcome of having purchased the S&P500 Total Return index.

Stock market investment performance over the 25 year mortgage term

Stock market investment performance over the 25 year mortgage term

Conclusion: The stock market performed strongly over the 25 year period, accruing a CAGR of 12.68%. However, contributions would have ceased once renting became more expensive than the mortgage payment.

Property ownership for the win

Would renting have proved to be a suboptimal choice over the last 25 years?

Buy versus rent: Accumulated equity after the 25 year mortgage term

Buy versus rent: Accumulated equity after the 25 year mortgage term

Conclusion: Absolutely, by more than one million pounds!

History doesn’t predict future performance

Will the outcome be the same over the next 25 years? Without a crystal ball, there is no way to tell.

During the accumulation phase of wealth management, building up equity rather than incurring expenses is vital. Whether that equity is accumulated in shares, investment properties, or owner-occupied real estate should be determined by the individual’s risk appetite and assessment of the investment landscape.

For most people housing is their second highest outgoing after taxation.

You have to live somewhere

The thing to remember is you have to live somewhere, and (unless you are freeloading off your parents) that residence is going to cost you something. That housing cost could be making money for someone else’s business, your landlord, or it could be accumulating equity for yourself.

Robert Kiyosaki is famous for stating owner-occupier property is not an asset, because it consumes rather than generates income. The charts here have demonstrated that well located real estate can generate significant wealth for the property owner, in a similar manner to a company or accumulation fund that chooses not to distribute dividends.

When combined with the careful application of leverage those returns can be magnified.

Do your own homework, as the prospects for any investment can vary considerably by locale and over time. Property is a long-term game, not least because moving sucks and you have to live somewhere!

Next Steps

  • Run the numbers on your own residence. Does it make more sense to rent or buy?
  • If you liked this post then please share it with your friends.
Disclaimer: I may receive a (very) small commission from any purchase you make via links on this website.
In the long run

My high school economics teacher used to defuse arguments with the saying “in the long run we are all dead”. He was quoting from John Maynard Keynes’ “A Tract on Monetary Reform”, which observed that the simplistic outlook held by Economists about an often uncertain world was about as helpful as the ancient Persian proverb “this too shall pass”.

Recently I’ve encountered numerous occasions where somebody said the current state of affairs is not “normal”,  and that over the longer term we should expect them to “revert to the mean”. They could have been talking about anything from interest rates, inflation, property prices, to cryptocurrencies.

What they really mean is they endorse Isaac Newton’s observation “what goes up must come down”… and they believe the inverse is also true.

what goes up must come down

For mine, “normal” is a subjective term that is very much defined by perspective and outlook of the observer. Usain Bolt and Stephen Hawking probably consider themselves to be normal (we all do)… they just find the rest of us wanting!

I decided to dig into the numbers, to figure out for myself whether there was anything to this talk of returning to “normal”, or if it was just a load of bollocks.

History of the world

In the long run we are all dead. Image credit: Lasse Vestergård.

758 years of inflation rates

First I looked at the annual inflation rates. Via the National Archives and the House of Parliament library, I found a research paper from the 1950s that tracked the annual price and wage inflation rates since the 1260s. I then extended the time series to today using figures from the Office of National Statistics.

750+ Years of United Kingdom Annual Price Inflation Rate

750+ Years of United Kingdom Annual Price Inflation Rate

There were some interesting results from analysing 758 years worth of data.

  • The average annual inflation rate was 1.53%.
  • The ride required to achieve that average was far from smooth, with annual swings of ±60%!
  • Deflation occurred in 44% of the periods.
  • Periods of 1970s style high inflation rates are not uncommon, though occur less frequently than they once did.
  • The recent extended period without much inflation rate volatility is unprecedented.

Conclusion: The often repeated 2% annual inflation rule of thumb holds true.

324 years of interest rates

Second I looked at official interest rates. The Bank of England once published data going back to 1694. While the original download is no longer available, the Guardian has republished a copy which I have extended using current Bank of England figures.

324+ Years of United Kingdom Interest Rates

324+ Years of United Kingdom Interest Rates

324 years of interest rate data told an interesting story.

  • The average interest rate was 4.71%.
  • Only 16% of the historical periods have experienced interest rates exceeding 5%.
  • The recent period of extremely low-interest rates is unprecedented.
  • The high-interest rates experienced during the 1970s and 1980s were also an anomaly.

Conclusion: The historical average interest rate is approximately 10x those experienced today. Ensure you stress test your debt servicing plans appropriately.

758 years of wage growth rates

Finally, I looked at annual wage growth rates. The research paper mentioned above had attempted to collate a time series looking at the weekly wages received by a “building craftsman”. I extended the series using Office of National Statistics annual wage growth figures, which resulted in the substitution of the average worker for a “building craftsman” from 1955 onwards.

750+ Years of United Kingdom Annual Wage Growth Rate

750+ Years of United Kingdom Annual Wage Growth Rate

The 758 years worth of data tells a story, though one that should be treated with caution as the time series contained several gaps, some of which were lengthy.

  • The average annual wage growth rate was 1.5%.
  • Historically wages do down as well as up, with declines in wages reported in 33% of periods.
  • Supply and demand play a huge role in setting wages. The effects of war, plague and famine plain to see.
  • The absence of annual wage declines since the 1950s is inconsistent with the preceding 700 years experience. This is most likely caused by the substation of average wages for those received in a specific vocation, rather than a structural change to the way the economy works!

Conclusion: Short-term wage growth is determined by supply and demand for skills, however over the long term it unsurprisingly parallels inflation.

In the long run?

In the long run both Newton and Keynes were right. With the benefit of distance and hindsight, all the daily volatility and noise smooths out into a nice understandable trend. The historical data examined here shows that when viewed in a 750 year context, the last 25 years have been an economic purple patch.

Next Steps

Disclaimer: I may receive a (very) small commission from any purchase you make via links on this website.
Money epiphany

My money epiphany occurred at 8:21am on a Thursday. As a thoroughly exploited, freshly minted graduate accountant, I emerged from the office bleary-eyed after a nightmare month end all-nighter.

I was heading home for a quick shower and change of clothes, when a fire engine red Lotus Elise sports car roared past me before screeching to a stop in the parking space next to my crappy student car.

My boss climbed out, looking remarkably fresh and rested, which was unsurprising given he had no doubt spent the night sleeping soundly in a nice warm comfortable bed.

He nodded hello, before pausing and asking where I was headed. I replied that I’d been working all night. Again. I would be back in half an hour.

The boss looked thoughtful, made some vague promise about having to remember all the extra effort I had been doing at bonus time, and then told me to pick him up some breakfast on my way back to the office.

Without waiting for an answer he headed inside, bound for his corner office.

When I reached my car I realised the boss had badly parked his sports car, half blocking me in. I briefly considered etching some thoughtful parking advice into his car bonnet with my keys, but I was so tired I couldn’t remember how to spell “inconsiderate”.

As I carefully performed a 20 point turn to extricate my car from its parking space without denting my boss’s shiny new Lotus, I reflected on our relative lots in life.

When Work Goes Wrong

When Work Goes Wrong. Image credit: LegoJalex.

Money epiphany: Compounding applies to time as well as money

By working in someone else’s business, any great work I did would earn profits for them.

If I owned the business, any great work I did would make profits for me.

If I then employed others, the great work they performed would also make profits for me.

In time I should be able to employ a manager to operate my business, which (all going well) would free up my time for other pursuits while the business continued to make profits for me.

In short: it is good to be the boss!

it is good to be the boss!

Bonus time… screwed with my trousers on

A couple of months later bonus time arrived. My boss made a big fuss about how much he appreciated all our effort, and presented each staff member with a cheque for a moderate sum.

Being an accountant, I automatically ran the numbers in my head.

I divided the bonus amount by the number of unpaid overtime hours I had worked.

It turned out I was making less per additional hour than I earned doing my paper route as an 11 year old!

Over the next couple of weeks, I sought advice from family and friends. Almost all were salaried employees, who talked about “paying dues” and “climbing the ladder”.

However none of them drove new red sports cars. Nor did any of them take off for surfing or skiing holidays nearly as often as my boss did.

Escaping life as a wage slave

Some months later I left life as a permanent employee, and started working for myself.

Twenty years on that one decision has generated me more wealth than any other.

Over the years I have accumulated a diversified collection of income streams including business ownership, direct real estate investing, a stock/bond porfolio, and equity investing in businesses owned by others.

In many ways I am grateful to that balding, pot-bellied, middle-aged boss with the red sports car.

He gave me the opportunity to start my career after university, after I had been rejected by 74 other potential employers.

He exploited me ruthlessly, which taught me the importance of control, and maintaining a strong negotiating position.

He demonstrated that life is lived by our own self imposed constraints. This includes:

  • Control over how we invest our time
  • Establishing for ourselves the value of our time
  • Being consciously aware that every hour worked has an opportunity cost.

Next Steps

  • What was your money epiphany?
  • Consider whether you reap the rewards of your efforts. Are you making money for yourself, or somebody else?
  • If you liked this post then please share it with your friends.
Disclaimer: I may receive a (very) small commission from any purchase you make via links on this website.
The long game

The highlight of my week was watching as Elon Musk’s SpaceX successfully launched a rocket capable of carrying a sizeable payload into space. I applaud their marvellous achievement.

For bonus points, they managed to successfully land two out of a possible three booster rockets for reuse in future launches.

To give credit where credit is due, Musk put his money where his mouth is. Not only did he spend USD$90 million on the launch, but he bet his own car on the outcome. He was either going to be the proud owner of the first sports car to drive to Mars… or the former owner of a flaming wreck!

Childhood dreams

Elon Musk had a dream of going to Mars, as most 7-year-old boys do. Unlike the rest of us, he played the long game and developed a collection of complementary businesses that generated the required income streams and technology necessary to achieve that dream. His net worth was estimated in the region of USD$20bn at the time he launched his Tesla into space.

The TOGAF Enterprise Architecture Framework can be summarised as identifying the current state, the desired future stare, and the incremental steps required to move from the former to the later.

Musk has successfully applied this approach. He identified the core components required to achieve his Mars dream, and then figured out how to make each one not just self-funding but also commercially successful. In turn each component contributes the cash flow and technology advances required to realise his strategic dream.

Playing the long game

Musk founded SpaceX in 2002, the same company that entertained me this week.

He then helped start Tesla in 2003, roughly 6 years after Toyota released the first hybrid-powered Prius. Since then Telsa has been developing a self-driving capability that will significantly reduce the time lost to traffic congestion, though at a cost of making millions of low skilled truck and taxi drivers structurally redundant.

Tesla

Tesla autonomous cars and batteries. Image credit: Arthuriel.

By 2006 SpaceX had proven reliable enough for NASA to award the outsourcing contract to service the International Space Station. By 2011 NASA was comfortable enough with the service provided to decommission the space shuttle.

Also in 2006, he helped start SolarCity. The stated goal was to expedite the world from a “dig it up or burn it down” energy generation method towards a more sustainable, infinitely renewable,  solar-powered future.

In 2015 SolarCity started selling a product called Powerwall, providing a battery backup option for solar power. This used the same battery technology that powered Tesla cars, allowing a further commercialisation of the battery technology.

By 2016 SolarCity had launched a roof tile product that harvests solar energy. What would your preference be: a roofing product that generates a passive income stream, or one that depreciates at the same rate yet earns nothing? That is a no-brainer.

Great ideas sustainably pay for themselves

Telsa cars have become an iconic fashion statement, with an 18-month waiting list. Much like Apple does with iPhones, Telsa could charge whatever prices they liked and still have customers queuing around the block.

The SolarCity power generation and storage capabilities more than pay for themselves within their useful lives. This creates a win-win, as the consumer ultimately lowers their power bills and their carbon footprint.

The money from those endeavours helps fund the development of the space ships, stepping ever closer to realising Musk’s boyhood dream. To me that looks like winning, regardless of whether you appreciated the humour of sending a Tesla driven by a David Bowie loving crash test dummy to Mars.

Next Steps

  • Have a think about your dreams, and how you could “go big” to achieve them.
  • Take stock of your diversified income streams. If they don’t fund your desired lifestyle figure out a way to remedy that shortcoming!
  • If you liked this post then please share it with your friends.
Disclaimer: I may receive a (very) small commission from any purchase you make via links on this website.