AAR21 - 5 Ratios to Understand Your Financial Situation

26:34Dave Ahern:That's what that money is there for. And I think something like three months, especially earlier on in life, is a good target to aim for that will be achievable for a lot of people. still give them some good padding behind them, but then also not demoralize them too much and give them a realistic target to aim for and then give them a ton more time to compound whatever money landed in investment savings instead of just in their high yield savings account or something like that. Yeah, well said. Very good. Appreciate it. All right, number four, we have the net investment ratio. To calculate your net investment ratio, I would take your total invested assets So these could be any assets or funds that are put away that are growing at maybe not a steady rate per se, but are growing at a noticeable rate divided by your net worth.

27:24Dave Ahern:So basically what this is giving you is this is the amount of wealth that you have accessible to you, how much of it is invested and growing at some significant rate versus maybe just sitting in cash, maybe sitting in an appreciating asset or something like that, not doing any work for you. but essentially is just money that's stagnant or even decreasing over time. And kind of a big ballpark range that I would say to aim for, because this can vary a ton by people's different financial situations, is trying to keep that above 40%, but I would also place a maximum on that of below 90%. And the reason for the minimum, the more obvious one, is to make sure that you have a good amount of your wealth in investment so it's growing over time.

28:06Dave Ahern:If you have all your money sitting in cash or all of it sitting in six different cars or something like that, the money is not going to grow. It might even decrease over time, especially when you take account for inflation. It's definitely noticeably decreasing over time. And so that money is not growing for you. It's just sitting there or even dwindling over time. The reason that I placed the cap on there at 90 % is to protect that last ratio, to protect having some kind of an emergency fund that maybe you prefer to keep it in cash. Maybe you prefer to keep it in the checking account. That's hardly if even growing whatsoever.

28:38Dave Ahern:But at least you have those funds accessible to you. And you're not prioritizing putting those in investments because heaven said to have your net investment ratio as high as freaking possible. And so you want to just throw all of your cash into investments and nothing else. That I think is setting you up for an issue of, again, your car breaks down. And now the only way you can pay for it is by using a credit card. and then I don't really want to sell my investments right now to pay it off because they're really down right now and I would take a loss on them. So I'll just let the credit card pay it off for another month or two and then I'll withdraw some investments and blah blah blah.

29:11Dave Ahern:It's just putting you in a bad place that would be much more sustainable and healthy if that money was accessible to you in the first place. And to discuss how to calculate your net worth is definitely a hotly debated topic and I guarantee you that if Dave didn't hear about that at FinCon, If he did, people would have gotten very heated about it. But from my point of view, including any of your assets, which could be your home, in my opinion, this is all my opinion, but including something like home equity, including cash that you could spend, including investments that you could sell, the retirement accounts that you could pull out of, any other assets like that that you could pull money out of and pay things off with, in my opinion, is an asset, especially if it's growing and earning you money over time.

29:58Dave Ahern:time and add that all up and you get your net worth. So yeah, the end goal is we just want to avoid cash sitting whatsoever and not growing at all and prioritize putting it into places that are going to grow. In your opinion, Dave, would you include something like a high yield savings account as an investment or would you only see something like in real estate or stocks or something that's growing at a more significant rate and isn't as spendable in your investments? I guess I would probably include a high-yield savings account as part of your investments, and here's why. When you think about setting up your investment portfolio, however you want to construct it, it's always a good idea to have some liquidity to it.

30:41And having money in places like a high-yield savings account or something like a money market fund, these may not make you tons of money, but they also give you liquid assets. And so to Evan's point about less than 100 % or less than 90 % of the net investment ratio, having some money in a liquid, and I'm not talking about, yes, having your emergency fund in a high yield savings account makes a lot of sense. But also maybe having a separate account that you keep liquid. And there's two reasons why that's a really good idea. Number one is it gives you a cushion in case the markets are being yucky and you need extra cash.

31:22Let's say you have a three-month emergency fund and something comes up that you need a bigger chunk of money. If you have to liquidate all of your emergency fund and some of the stocks and the market is down, that's not a great place to be. And so I'm a big fan of having options and having choices to be able to make on how you want to maneuver during some of these different life challenges that you're going to get. And so having some money in something like a high-yield savings account that may be separate from the emergency fund as part of your investments is certainly, I think, a good idea or a money market account.

31:59Either one of those kinds of things that gives you some liquidity and is also earning you some money. And then the vast majority of your wealth, I would try to put in places that are going to grow much faster, whether it's bonds or whether it's your 401k or whether it's maybe not Bitcoin, but maybe if you're playing in the stock market, it doesn't have to be individual stocks. It could be index funds, ETFs, things of that nature. And there's lots of different ways you can, I guess, arrange or manipulate those things. But yeah, I'm a big fan of having optionality. And I'm a big fan of having some money set aside in a high yield savings account.

32:34Also, because if the market does draw down, then instead of having to liquidate some of your assets to buy more stocks, for example, if you have cash sitting in a high yield savings account, you can literally just take that out, transfer it to your brokerage account and buy everything that's on sale at the time. And so that's another great way to do it. And then over time, you build the high yield savings account back up. So I guess that's how I would try to look at it.

33:00Dave Ahern:Yeah, I actually really like that. I especially like the idea you had of having separate portions of your high-held savings account that are used for different things. Your very liquid spending or your emergency fund that you really don't want to touch unless you really, really have to. I think that's a really good way to go about things. It helps you mentally segment things, segment portions of your money so that you're not accidentally dipping into too much, but also not too scared to dip into money when you need to because you feel like I wasn't supposed to touch that or whatever. It does a much better job of breaking up your wealth in a more sustainable way.

33:33Dave Ahern:Also, what is your opinion on what to include in your net worth? How do you personally go about calculating net worth? I look at it exactly the same way you did. The home equity, cash investments, retirement investments, any other assets you may have, whether it's property, whether it's vehicles, boat, guitars in my case, any of those kinds of things are assets. And I would consider those part of my total net worth. Did you hear any heated debates about that? I did not. It was all about saving money. All about saving money and whether index funds were a waste of time or not. Oh, okay. I will be very interested to hear about that, actually.

34:13Dave Ahern:But on that note, we're going to move on to our last, our number five ratio, which is the debt-to-income ratio. And I'm sure that a lot of you have heard about this before. This is a common and hotly debated and possibly mentioned to FinCon, as all of these probably are, ratio, which you calculate by taking your monthly debt payments divided by your monthly net income. And I would say trying to keep this below 30 % is a good figure to aim for. And what this kind of tangibly means is you're including any payments that you have to make on a regular basis to pay down any debt you have. So maybe this is your mortgage that you have to pay down.

34:51Dave Ahern:Maybe this is a car loan you have to pay down. Maybe this is a personal loan. Maybe it's past credit card debt that you're paying down. We're taking into account any steady monthly payments that you have to make towards those debts and dividing by your monthly net income. And what that gives us is a good idea of how much of your money you're able to spend and save where you want or where you need to spend it as opposed to where you're being forced to spend it and you're not really getting, per se, you're not really getting any value back from it. Now, I will say that one little aspect of this little caveat for me personally, how I calculate stuff, is when I'm looking at my mortgage payment and counting that as a debt payment, I actually subtract out, based on the amortization rate, how much of those payments is going towards equity.

35:40Dave Ahern:Because in my opinion, if I'm putting money into the home and now I keep that value myself, I could still pull that out or sell the home or whatever and that cash could be mine. Then in my opinion, that is still my money and that is still an asset, even if I was forced essentially to save it and put it in one place. However, the rest of it that's just going towards interest and is just going to the bank or the lender and I'm not seeing a penny of it anytime in the future. That is definitely a debt. And again, same could go for a car payment. If you are paying down the car and you're not underwater on it and so as you're paying it off, you're earning essentially more equity.

36:13Dave Ahern:You own more of the car. So if you were to sell it, you could turn that into more and more cash. Then those could be places where you could argue that it's a savings amount of money that's going somewhere. At least it's cash that you're going to be able to hold on to. But again, those are all numbers that you can play with yourself and see what feels most realistic for you and what gives you the best perspective of where you're personally at. But we want to, in the end, we just want to avoid drawing down all of your money and all of your income into just paying debt. Debt to income, definitely a hot topic.

36:43Dave Ahern:How do you feel that people handled that when you worked at a bank? Because I'm sure you heard a lot of horror stories about how people were managing their money and issues they were going through. I've definitely heard some of them before. How did people handle, what kind of debt to income ratios did you see when you were there? One of the things about Bitcoin that's really surprised me is how much easier it is to transact with these days. I was always under the impression that using Bitcoin as payment was inefficient, expensive, and risky, but Cash App has made it easy. It seems like Cash App is being accepted by more and more merchants everywhere I look.

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38:00Dave Ahern:I've been paying a lot more attention to what's actually happening inside my body. When I train lately, especially when I hit a wall with my performance and nothing I do seems to move the needle. What surprised me is how much of how you perform and recover actually comes down to what's happening in your blood. Markers most people never think to check. Here's what most people overlook. Training gives your body the stimulus, but your internal environment determines what actually happens next. Things like your glucose, whether your body is burning clean or running on fumes. Your omega-6 to omega-3 ratio.

38:27Dave Ahern:Which one is winning the inflammation battle after pushing your body? Your DHEAS, one of the building blocks your body uses to make testosterone, and one of the first things to quietly decline without you noticing. When these markers are off, the right moves don't hit as hard and the wrong moves hit way harder. When they're dialed in, the work you put in actually pays off. That's why I use Function. 160 plus lab tests a year so I can see exactly what's going on under the hood, not guess at it. If something is working against my performance, I want to know. That's what actually taking your training seriously looks like.

38:57Dave Ahern:I use this and you should too. Check your health the way I do. Function provides 160 plus lab tests for a dollar a day and member pricing on MRI and CT scans. Join at functionhealth.com slash beginners or use gift code beginners25 for a$25 credit toward your membership. It wasn't something that we calculated necessarily at the bank, but there was, we should have in hindsight, there was a lot of people that were well above less than 30 % of their net income that were on debt payments. And one of the things that, frankly, I wish I would have known about this ratio when I was at the bank because it would have been very helpful to illustrate to people, sit down with them and go, okay, here's how much you're taking home.

39:42This is how much you're paying in debt. And just to be able to break it down, one of the ways that I think about it personally is I think of things that are, I would call them fixed debt versus variable debt. And when I think about fixed debt, I think about car payments and I think about a mortgage payment or rent if you have rent. And to me, that is a fixed payment. You have to make it every month. And yes, you are getting equity out of the mortgage payment and to a certain extent the car. You're also getting some equity out of the vehicle. But I look at it as a debt payment. And then I look at the variable debt.

40:16And that's where people get slaughtered is in the credit card debts or the buy now pay laters or the revolving debt that they may get into with their cashing their checks at places. All those kinds of things that become a variable debt that is revolving. And A, the interest rates are generally a lot higher. And so the amount that you're paying every month is a lot higher. and you're not really seeing much for that. To Evan's point earlier about the majority of what you're paying when you make a$200 payment to the credit card, the vast majority of that is interest. And it just keeps piling up and piling up and that's where it gets really dangerous.

41:01And I saw a lot of people living well above their means and the vast majority of it was because of this very thing where maybe the husband and the wife together are making$250 ,000 to$300 ,000 a year, but they're also probably sitting at 60 % to 65 % debt payments to their net income because they were buying two or three cars. They had a home. They had a vacation home. They were buying a boat. Or in Minnesota, they were buying a boat and a snowmobile. and they're going out to eat maybe not once a week but four or five times a week each. So they were eating out for lunch, both of them at work and then going out to dinner with friends in the evenings.

41:51And I'm not saying that those things are in and of themselves bad but when you're using credit to fund that part of the lifestyle, that's when it starts to become a problem. And these people that I'm speaking of in particular, they were making 300k a year combined and they were paycheck to paycheck they're underwater on everything they owed more than they owed if i had sat down with them and try and calculated their net worth it would have certainly been less than what they were making and so it was it was a dangerous place for them to be and they were miserable they were not happy people even though you would think making all that money it just was a not a great situation for them and i they They were not alone.

42:34I saw lots and lots of examples of that from a wide range of income earners. And so to me, having an idea of what your fixed payments are versus what your variable payments are and trying to manage those, I think is a really, that's how I tried to help people with it. And it's how I try to think of it. But I like your little addendums with the equity that you're earning on the house and two, because I think that's an important thing to see. But I think this is a really important ratio. Probably of the ones we've looked at today, I would say this is probably the most important one to look at or the one that I would focus on the most because both Americans in particular, I'm not going to single out people from other countries because we tend to be the worst at this.

43:14we spend more than we make and it's endemic in our society and we live on credit and it can be a very dangerous place to be and so understanding what this is can be very helpful and very enlightening if you haven't done it and sat down and do the work to figure it out you're going to be shocked

43:31Dave Ahern:and it's only getting worse nowadays with stuff like clarna and like you said to buy now pay later when we were when we're shopping for furniture which we're definitely not anywhere near done But when we were shopping for furniture, when we got the house and the worst example of it that we saw was, I believe it was Ashley's furniture. When you walk around that store, a lamp is$3. A couch is$16. That's literally what the signs say is this couch is$16. And then in very small print, it says per month. And then it says make 12 months of interest-free payments and all this sort of stuff. It is the entire store is geared around you could furnish your entire house for 150 down or something at a 150 a month quote unquote.

44:17Dave Ahern:And it's people could so easily just pile in to debt. And it was really scary because I saw how somebody in my situation who doesn't just have a ton of free cash to just buy all the furniture that they want and not even give a second thought about it or anything and just got a home and needs to get some stuff and walks into that place and says, oh, I didn't really think we could afford this like big L couch right now. But I mean, it's only 13 a month or something or 13 up front. And suddenly it feels very affordable. And you're like, well, what's the downside? It's interest free and everything.

44:51Dave Ahern:and theoretically if you play it right, then you might be able to work it out, but some companies will force you to pay interest. So even if you pay it off early, you still have to pay off some of the interest that you would have paid them if you've held onto it. There's a lot of tricks they use to make it seem 100 % good, no downsides to this, when that's not the reality of it. And stuff like that is very, very scary that people can fall into so easily. And then a year and a half, two years down the line, get in a place where they have this mountain of debt of just furniture or cars or houses or whatever that seemed very affordable up front.

45:26Dave Ahern:And maybe one by one, they were affordable. But like you said, when you start piling it on more and more because they look affordable up front, all of it together is not going to be affordable. And when you actually sit down and calculate that debt to income ratio, it's going to give you a good idea of, okay, I felt like I was just spending on wants. And if you had bought the whole couch at once, then yeah, you did just spend on a want. but if you're now still going to be paying for that couch three years later and if you don't pay it off you're going to be paying interest you're going to be pursued by them legally whatever now it has become a need you have to pay that off and it's become a debt that you have to pay off every single month and you are suddenly not going to have nearly as much of your net income left to spend as you plan to up front and that is that's a scary place or and we've got a i've actually got a quick bonus ratio at the end of it so technically six we could change the title if you would like if we get enough complaints is if you're in a relationship having some kind of a partner income ratio now i want to be very careful with this that this can definitely go down the road of toxicity and go down the road of judging people and all that sort of stuff if you're in a relationship where you're comfortable discussing finances and especially if you're married or rely on each other financially rely on each other to pay housing payments pay food pay for children's medical visits or something like that, where you rely on each other financially, I think that calculating something like this can be very useful.

46:49Dave Ahern:And all this is a ratio between like your income and your partner's income or vice versa. And I've discussed this before, but for me, this is a very important ratio because it stops the couple as a whole from spending one of the people into oblivion, sort of. Spending them to a point where they have to take on debt to afford it, where they're stretching themselves financially and can't afford anything they want anymore because they're having to just keep up with the other person that is really the worst place that this ends up and i have definitely socially seen that with people that i've known or indirectly known where one person makes a bunch more money than the other person and thinks well i'm making all this money i can live lavishly blah blah blah and but doesn't feel like they need to carry any more weight even though they're making more money because they think well it's a partnership it's 50 50 and everything.

47:39Dave Ahern:And while I definitely get that in a lot of other places, if it's in a place where you're signing the other person up for the same level expenses, and now they're chained to the same fence, so to speak, if they can afford to keep up with that, then I think that's putting them in a bad situation. And that's also putting a relationship in a bad situation. So again, only if you're in a couple of relationship that you're comfortable discussing these kinds of things, having that kind of a ratio to say, okay, I'm 60 % of the total income, I will cover 60 % of those fixed expenses helps that person out a little bit while not, that's realistically not going to take that much from you because you're the one earning more money you can afford to take on that little bit of extra burden.

48:18Dave Ahern:And that, in my opinion, can go a long way. Dave, do you agree with using a ratio like that? I think I would. And I also would probably recommend in conjunction with that, we talked a little bit ago about doing monthly meetings, kind of a financial situation, where are we budgeting tool. If you do that in conjunction with that, I think that helps clear up any sort of confusion or make sure that everybody's kind of on the same page. So I think that could help alleviate any sort of toxicity or any sort of finger pointing or blame game because I think when both partners are open about what they're spending, where the money is going, there's a lot less ambiguity about it.

48:58And so it's also easier to kind of head all that off at the pass. and so that's why I think this in conjunction with monthly meetings I think would be amazing

49:07Dave Ahern:100 % then it puts you on that evil sorry not evil equal level playing ground mentally where you're both going into this check-in this meeting quote-unquote to to be ready to discuss something like that and not just blindsiding them while they're folding laundry or something like that it's like how much do you make how much is your car payment if you didn't know before that is not that's not going to lead to a fruitful conversation i don't that will not go well if i was no no one last question i have for you dave are there any other ratios that you've used in the past or wish you would use in the past something like the debt to income ratio that helped clients the most or could have helped clients the most i think uh the savings rate emergency fund ratio and the debt to equity that i mentioned earlier i think those three would be hugely helpful especially for people that are newer to budgeting and managing their own money or a couple's money.

50:00I think having kind of a basic outline of what those are and how to calculate those and looking at those on a regular basis, I think would go a long, long ways towards people having some sort of financial freedom and some clarity on what's going on with their money. And because you would have a better sense of, okay, am I saving enough? And do I have enough backup in case I do have a problem? and am I managing my money well as far as using the assets that I have to do the things that we need to do? For example, with your buying furniture, if you have an emergency fund or you know you're going to be buying a house, you can beef that up in advance of having to buy furniture so you don't have to do the buy now, pay later game and go, hey, I can get everything for$120 and six years later, you're still paying for that lamp.

50:50So I think having some of the pieces are in place before you start the process, I think would be hugely, hugely helpful. And I wish I would have had these tools to help explain because it would have been a lot easier to sit people down, map everything out, and go, here's where we are, here's where we need to be, and this is how you can do that. I think that would be tremendously helpful.

51:13Dave Ahern:Beautiful. Yeah, I think that's a good triangle of coverage to cover everybody's financial situation. I really love that. And as a reminder to calculate these ratios, I would recommend having some kind of a budgeting spreadsheet or a net worth spreadsheet, something that kind of gives it, it gives that spreadsheet already a good overall idea of your financial situation. And then you can very easily just have a few calculations occurring off to the side. You could write them down over time, or you could just mentally track them and get a good roadmap for how you're performing over time. But I would, again, not take any of these numbers, take these numbers with a grain of salt.

51:46Dave Ahern:And I also wouldn't recommend just Googling and saying, okay, what number should I be at? Blah, blah, blah. I would just say, this is the number I'm at, and I want to improve this. Bang. That is all that matters. Up 1 % is more important than being at 51 % or something like that. But with that said, again, thank you so much for your help, Dave. I really appreciate it. I think today was a really freaking good episode, and I think it can help a ton of people. And if you want a budgeting spreadsheet or something to help you set up your finances and then maybe have some of these ratios plugged in off to the side, then you can go to einvestingforbeginners.com slash budget, and that'll give you a very easy spreadsheet to get started.

52:19Dave Ahern:Or if you have any questions or any ideas about these ratios or any other ratios you personally use, feel free to email me at evan at einvestingforbeginners.com. And as always, remember financial freedom is built one smart move at a time. Keep it simple, keep it steady. And at any rate, I'll see you next time. Peace. The information contained is for general information and educational purposes only. It is not intended for a substitute for legal, commercial, and or financial advice from a licensed professional. Review our full disclaimer at einvestingforbeginners.com.