Sunday, May 13, 2007

Practical Wealth V. Phantom Wealth: Time Your Money

Time Is Money

Timing Is Everything

"Biggest Net Worth Mistakes: Is Your Net Worth Accurate or Useful?" covered how "net worth" and assets can trick you into the illusion of financial health (phantom wealth). Instead of net worth, use realistic measures of accessible wealth to rate your fiscal health. Too many people ask the "How much?" question but forget the crucial "When?" question.

Liquidity: WHEN you have money is as crucial as HOW MUCH.

Try calculating your wealth in the standard money measurements of liquidity to measure how much buying power you actually have at different time horizons, from immediately through the medium and long terms: Make your own personal M0 (“M zero”), M1, M2, and M3:

  • M0 = Cash.
  • M1 = M0 + checking or other “demand” accounts.
  • M2 = M1 + savings accounts up to and including insured CDs (<$100,000).
  • M3 = All money.
Compare cash with obligations at each time horizon (week, month, year, before age 59 1/2, etc.--including any withdrawal penalties). What if you lose your job, get sick, wreck your car, or have a house fire? You should have cash for small or likely or short-term events, scheduled liquidity for medium-term events, and use available credit or insurance only for the biggest, unexpected, unaffordable events.

Working Capital a.k.a. Operating Capital
Current Ratio = current assets divided by current liabilities
"Current" means liquid, liquidatable, or due within a time period. A potential pitfall is that, with a time period such as "this year," current assets include expectations of future income: Beware of relying on Accounts Receivable, including future wage paychecks, because they are not "a bird in the hand." If you have been opting for overtime pay recently, that precedent is no guarantee that you always will be able to choose your take-home dollar amount. Do not count your chickens before they are hatched.

Liquidity Ratio = liquid assets divided by expenses
Assume your income suddenly becomes $0. How long would you last? A typical recommendation is a 3-6 month buffer, and the self-employed or irregularly-employed are more likely to keep even bigger buffers for longer lean times.

Accurately Rate the Liquidity of Your Non-Money Assets

Rate the realistic time horizon for liquidating the asset (Week? Month? Year?) before you include it in your appropriate "time horizon" assessment of wealth.

Be very cautious in counting non-money assets because their ownership is "sticky" (resistant to change). The stickiness might be due to legalities such as a car title, or regulations such as car inspection (it is grandfathered but would fail a new inspection), or transfer costs such as a sales tax. Both time-to-sell and sales-price can change with events, such as a CNN expose on how your car model is a death trap.

Even more importantly, emotional attachment is another form of stickiness that confuses investment with consumption.

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