Using Financial Cairns to Guide Your Journey
A few years ago, on a hike in Colorado, I had my first experience with cairns. A cairn is a human-made pile of stones that can be used for many things like noting a landmark, or in this case, indicating the best path forward for hikers–essentially marking the trail to the destination. In our case, the cairns appeared after we got above the tree line. This was my first hike above the tree line. As you step out of the trees and see the mountaintop above you–still so far away–it is both an awesome sight and daunting to realize that you are out in the open and have a myriad of options to get to the top. How do you know you are on the right path? In our case, we followed the cairns with the expectation that they will get us safely to our destination.
Sometimes, it can feel like reaching financial independence is a lot like looking at the top of the mountain from tree line. It is up there somewhere, and there might be a lot of ways to get there. How do we decide the best path forward and–more importantly–monitor our progress? Fortunately, there are some financial cairns we can use that I outline below. I have found the best time to calculate most of these metrics is usually after I get my tax return, but some can be calculated at the end of each calendar year.
1. Net Worth
Net worth is calculated by adding together all your assets and subtracting your liabilities. For younger people who are just getting started this can be a more accurate metric of your financial progress than portfolio value since extra income may be going to pay off college loans or other debts. A reduction in debt will not show up on your monthly investment statement, but it will on your annual net worth statements as they show a broader picture of your financial progress. Assets – Liabilities = Net Worth
2. Personal Savings Rate
To calculate your personal savings rate you will need a few things. First, to find your income, look to your Federal Tax Return, Form 1040, and find line 7b, which is your total income. Secondly, calculate the net amount of savings over the last year by adding together contributions to things like your, 401k, Roth IRA, Traditional IRA, brokerage account, and money market accounts. If you took any distributions from your savings make sure to subtract that from your total savings amount. This will give you your net savings amount for the year. Finally, divide your net savings amount by your total income, and you will have your personal savings rate. I am often asked what this rate should be. Generally speaking, it should be whatever it takes to meet your financial goals, but a good rule of thumb is least 15%. Total Net Savings/Total Income = Personal Savings Rate
3. Goal Savings Ratio
I sometimes like to call this the accountability ratio, and in my opinion, this ratio is more important than the personal savings rate listed above. It takes the general savings rate and applies it to your situation. To calculate this ratio, use the net savings amount calculated in your personal savings rate and divide it by your goal savings amount. So, for example, if we decide that you need to save $12,000 per year for various goals and you saved $10,000, your goal savings ratio would be 83%. In other words, you funded 83% of your planned savings goal for the year. Obviously, the goal would be to have this ratio at 100% or more. When that ratio is not 100%, it is important to examine why you were not able to reach your savings goal. Recognizing the “why” is important to determine what changes may need to be made in the plan. Total Net Savings/Total Planned Savings = Goal Savings Ratio
4. Percentage of income to taxes
This metric is more informational as you do not have total control over it. Still, it can be helpful to see how much of your income is going to taxes. In some ways, the savings ratio and tax ratio can work in tandem. For example, if you put more money into your 401(k) or IRA, your savings rate will go up and the percentage of your income that goes to taxes may go down. To calculate this ratio, refer to your Form 1040 again, and divide line 16 (total tax) by line 7b (total income) to see how much of your income went to taxes. Total Tax/Total Income = Percentage of income to taxes
There are many other ratios you can use to determine if you are making progress towards your financial goals. Some will be more relevant to your situation than others, but the four listed above are good baseline indicators we all should be tracking. If you are a client of Stewardship Advisors, our client portal will help gather much of the data needed to calculate these ratios, and together we will make sure your financial cairns are leading in the right direction.
