Four Factors in the Wealth Equation

January 19, 2023

I’m in the midst of year-end reporting right now, and needless to say, reports from 2022 will not make the best seller list! It was a challenging year across virtually all asset classes. Even supposed “safe” assets such as bonds declined double-digits.

After a down year, it is easy to get concerned about the investment process and lose sight of your overall objectives. You know my high-level advice – breathe in and zoom out. But if you are craving a more tangible exercise to ground yourself, give this a try.

When markets get rocky, I like to revisit the four factors that drive wealth accumulation (for myself and with clients). I run thru each of the factors, check if there are improvements to be made (for the two I can control), review my initial thinking/design, and remind myself that wealth accumulation is a well thought out process that stands the test of time – even after a negative year.

Don’t worry – this isn’t the actual calculation!

In case you wish to run thru this yourself, here are the four factors: Inflows, outflows, your desired risk profile, and the return that results from the chosen risk profile. Let’s touch on each of these.

The first two are in largely in our control – but ones that are easy to lose sight of if we aren’t careful:

1.)Inflows (what you earn)– Most of us focus on spending (see next). But earnings can be more important over time. Revisit what your current earnings are. Is there any room to seek a promotion, advance your skill set, pick up additional work, expand your business offerings to increase revenue? Or are you at a comfortable level of earnings based on your plan?

(Note: If you are already in a spending/distribution phase of your wealth journey, you can still look at your income sources. Evaluate pensions, social security, and portfolio income and determine if that level is still sufficient. Are there ways to improve your inflows)

2.)Outflows (what you spend)I’ve written about budgeting in the past but it’s worth repeating. Controlling your spending is an exceptionally important factor in wealth accumulation. Very few investment returns can outpace spending that far exceeds earnings. Limiting your spending allows you to deploy those extra funds (ie: earnings you don’t spend) into your investment portfolio at all market points and accelerate your wealth accumulation. Review what you’re spending and reign it in as needed.

(Note: If you are in the spend down/distribution phase, it is still very important to review your spending. Earnings may be harder to control at this stage – but limiting outflows is usually possible to some degree)

3.) Risk – your number one job as an investor is to remain an investor – no matter what. The studies of wealth destruction by investors doing the wrong thing at the wrong time (ie: selling at market bottoms, buying at market tops) are endless. You need to stay the course. But you also need to stay sane while doing so. This is where risk tolerance comes into play.

As soon as you start accumulating wealth, you need to determine how much volatility you can endure (the variability in returns you can withstand without being tempted to exit). You can do this in a variety of ways (modeling, shock testing, a “gut check” after a tough year (see 2022)). Based on the results of that exercise, you then established a target allocation (ie: % you will invest in various asset classes) that will allow for a given risk profile. That target allocation may change over time as your life circumstances change (ie: you approach or reach retirement). That is fine – but do not change your target allocation just because you experience a down year. Why not? See factor #4

4.) Return – this is the one factor you don’t have control over. Your risk profile and resulting target allocation will result in a given expected future return. The expected returns are based on many inputs (including projected path of interest rates, growth, productivity, etc). The expected returns are estimates annualized over your wealth journey – and are highly unlikely to be earned in a straight line. Said another way, if your plan results in an annual expected return of 5%, you will not earn 5% per year. You may earn 10%, lose 3%, earn 4%, lose 15%, etc – all of which add up to a 5% annualized return over the longer term. Staying invested is a key factor in realizing those longer-term expected returns. If you deviate from your plan, your plan simply won’t be able to do its intended job.

These four factors taken together will dictate the wealth you will accumulate and the financial goals you will be able to achieve.

Wealth accumulation (and its ultimate distribution) is quite a journey. Without a doubt, it’s full of judgment and emotion and qualitative factors. But it’s also a quantitative math equation. In times of high emotion, consider revisiting the “math,” and control what you can control. Review your equation and ensure you remain on track to reach your objectives. Then step back, exhale, and allow the wealth equation to do its job.

Onward we go,

Note: All commentary above is as of the date of this post and is for education and informational purposes only. Windermere and its principals do not intend for this to serve as investment advice and are not responsible for any actions taken based on this article. Consult your financial advisor before taking any actions as it relates to your own investment portfolio

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