Financial well-being – Part 2

In the 1st part of this series on Financial well-being, I had emphasized upon the importance of positive cash-flows. I invite you to read the previous post in this series, Financial well-being – Part 1.

Let us take a closer look at the term ‘financial well-being’. Our definition of financial well-being is completely independent of the size of one’s bank balance. In fact it is not at all difficult to find people who are affluent, but do not enjoy financial well-being. You’ll see from the examples that it is quite a common situation. This realization has been the single most important learning of my life.

Dark_Expense-conves-and-income-concave.031

The picture here explains financial well-being in a simple but succinct way. The chart on the left is an example of a person’s income and lifestyle-expenses, plotted over time. Here we can see that while the income increases over time, it’s clearly not being compounded. When you compound earnings, the graph takes a convex shape (refer to our earlier post on compounding here), which is not the case here. On the other hand, the lifestyle-expenses are getting compounded over time, and after a certain point the pace of increase is faster than the income growth. So at a certain point of time, while the income growth slows down, the expenses overtake the income and accelerates. Add inflation to the mix and the situation gets even worse. The chart on the right plots this person’s financial well-being with the growth in income. We can see that even though the income increases, the financial well-being is severely concave and after a point of time it plateaus out and then decreases. Here the cash-flows become negative after a point, and the person dips into his/her savings or relies on debt, to fund the growing expenses. He/she would have relied on debt to fund several non-cashflow generating investments, which can also be dangerous. Examples of such investments could be – own residence purchased at a premium, non-dividend paying stocks bought at high prices (refer to my earlier post on Margin of safety), illiquid investments etc. This person could be a multi-millionaire but can eventually go bankrupt.

If the person has a very sizable net-worth or a very high salary income, it can actually be even worse. This negative cash-flow situation remains well hidden under the weight of the person’s bank balance or salary cheque. It’s all great as long as luck remains on his/her side. However, the hidden danger gets compounded over time and all it takes is a few shocks (black-swans) for financial disaster to happen. Such black-swans can be in the form of job-loss, stock market crash, prolonged health issues, unexpected legal problems etc. This is a very typical situation that many rich celebrities or lottery winners often face. When they suddenly earn big money, they upgrade their life-styles at a much faster pace and this lifestyle is sometimes irreversible. It is also very difficult to maintain the same income growth over time if no compounding is involved. This coupled with bad advice from greedy or dishonest financial advisors, peddling bad investments and charging high fees, often lead to their ultimate financial demise.

Compare this with the situation, where a person compounds his income over time and keeps his lifestyle expenses in check, albeit enhancing the lifestyle over time reasonably. The situation here is exactly opposite to the situation in the previous picture. Over time the financial well-being not only increases, but it also accelerates (graph on right). For the mathematically inclined, the 2nd derivative of the financial well-being curve is positive, and this is the best thing that can happen to someone. The only problem is, it does not happen over-night. As you can see from the picture, the financial well-being takes time to accelerate, and it takes a lot of discipline to enjoy the snowballing effect.

Dark_Expense-concave-and-income-convex.031.032

The bigger advantage of this positive cash-flow situation is that it enables one to get the optimum returns from one’s longer term investments, which could even be unrelated to the components of this picture. I will discuss this with some examples in the Part 3 of this series.

My question for you is – you would like your personal situation to be represented by which graph?

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