Your Liabilities Are Your Real Benchmark

We often define success and performance purely in terms of market gains. Think performance markers such as whether your investment portfolio beat the S&P/ASX 200, or your salary increased a certain percentage.

But at the end of the day, it’s our liabilities and expenses that matter – in more ways than one.

So you should ask yourself:

• Do my assets and income cover my expenses now and into the future?
• What is the quality of my liabilities or expenses?

To use investment management terms as a catch-all summary: your liabilities are your real benchmark.

Understanding this and being able to carefully answer the above two questions can feed back into your financial decisions, both in terms of your budget and your investment plans.

Why Do Liabilities Matter More Than Returns?

There are two ways of thinking about liabilities as a measure of performance. One considers budgeting and your present, the second considers investment planning for the future.

Either way, keep in mind that your true return is the difference between your income and your expenses, both in the short term and the longer term, not the difference between your income this year compared to last year, or your investment returns compared to an index.

If you start with the concept of budgeting and the present, the old wisdom of not spending more than you earn comes into play.

The idea here is that it really doesn’t matter what gains you see in your income or investments if you can’t pay for your debts – or if in real terms, you haven’t actually come out ahead.

You might think of someone drowning in credit card debt as a primary example of this – but it can also apply to people who appear to be managing their expenses. In this situation, it’s about what they have left after paying those expenses and how this figure might shift.

One example of this is receiving a salary increase of 3% in a given year. However, let’s say that same year inflation increased by 3.5% with expenses like groceries and transport increasing accordingly.

In real terms, you are actually behind, despite the pay increase, because your liabilities increased more than your income. While you may still have savings left after your expenses, it is less than in the past.

Similarly, a retiree who has fixed income investments generating 2.9% above the cash rate is likely to be worse off in the same situation where inflation increased by 3.5% due to those same increasing expenses.

When it comes to an investment portfolio, there’s the present result – which may mean you experience a poor outcome, despite seemingly outperforming an index – and the future potential.

Consider an example of an investment portfolio that outperformed the index by 4.3% and was purchased using a margin loan. In theory, the index outperformance is a solid result, until you see that the index finished in the red and that across the year, you experienced a margin call. Perhaps you were able to pay the call, or perhaps you had to sell some of the investment at a loss to cover the loan.

This may mean that you’re not necessarily in the black for the present year from a basic finance perspective.

Experienced investors know that one year is not the complete story when it comes to this example.

Though you’ve had a loss when considering both gains and liabilities for the present year, that same portfolio might have the potential to offer longer term financial value for you so you may reframe your benchmark here away from the present day to what it means longer term, particularly when you no longer have to factor in loan payments.

Taking an Analytical Lens to Your Liabilities

Considering your liabilities as your benchmark is not dissimilar to how you might analyse a stock for inclusion in your portfolio. After all, an analyst would never just consider a company a BUY on the basis of revenue, or assess its annual results that way either.

When you analyse a stock for your portfolio, you’ll look at the company’s two types of expenses:

1. Operating expenses: the costs of being able to do business, such as employee salaries, rent for office space or marketing and advertising. Research and development generally falls under this too. For a person, these might be your rent, grocery bills, transport costs, or credit card debt.

2. Capital expenditure: one-off costs for long-term value, such as purchasing equipment, acquiring a new business or new technology. From an individual perspective, this might look like mortgage repayments, purchasing investments for your portfolio, or paying for a specific course for an industry qualification to benefit your career.

Then they might be termed as fixed (permanent costs, such as rent) or variable (these change based on your activities, such as travel and entertainment).

When it comes to a company, you would compare these figures to revenues and income to determine profitability. For a person, you would use your income, like salary and investment returns, as a comparison to determine available cash for saving or spending.

Finally, you need to consider long-term sustainability. Based on current patterns of spending, forecast income streams, market environment and assets, can a company continue to service its expenses in the future and generate a profit? Likewise, can you continue to service your expenses in the future based on your income streams – and did you actually come out ahead in the present year.

Of course, you’ll need to consider the quality of your liabilities – good debt (your capital expenditure expected to offer future value) and bad debts (more likely to be operating expenses that won’t offer later financial returns).

Some debts, like groceries, rent or transport, are ones that are necessary but won’t change your financial future for the better. Ideally you don’t want to overspend your income or take out loans on things like travel and entertainment, or luxury items, where you won’t see a future return.

On the other hand, taking on loans for things that have a later value – like an investment portfolio, your home or an investment property or qualifications to support your career – may offer a better return down the track despite temporarily lowering your income while you pay for these.

There is a caveat to the idea of ‘good debts’ though – that you can afford to repay these on your existing income. Ending up in default, even with the best of intentions, is of no benefit to your finances. Regardless of how nice that investment property looked, you’ll just end up needing to sell it to cover your debts, leaving you potentially worse off in the long term.

Matching your Liabilities to Income

Taking charge of your liabilities and being clear on what these are can also assist with investment planning.

For example, if you know that you have specific fixed lifestyle expenses, it will help you assess what level of risk and styles of investments you may need to consider in order to cover those expenses, particularly in retirement.

Many retirees would appreciate this firsthand.

While interest rates have risen more recently, retirees experienced nearly two decades of low rates and rising inflation meaning they couldn’t rely on traditional fixed income investments for their returns. Comparing to an index may have looked positive, while comparing to an individual’s liabilities and incorporating inflation numbers changed the real return. This saw many retirees move into assets generally classified as riskier, like equities, or use alternative styles of investment to support their growth and income needs.

This also applies to younger investors planning their goals and future liabilities. Will a certain mix of investments offer enough potential to achieve a goal of home ownership, for example? Or is the need to cut back on luxuries this year to pay for a qualification offset by future earning potential?

The Benchmark of Success

Benchmarking your income and returns against your liabilities can give you a clearer picture of your overall finances. It might explain why you feel behind one year when your salary has increased and your portfolio beat the index. It can help support your investment decisions by showing you what level of returns you need to cover your liabilities.

Finally, it can also help you make intentional decisions about where and how you spend your money (that luxury item is fine if you can afford it and it’s in your values). Or taking a loan within your means to pay for a critical qualification or to buy a high-quality investment might help you plan for a better financial future.

Your liabilities offer you a true benchmark.

Disclaimer: This article is prepared by Sara Allen. It is for educational purposes only. While all reasonable care has been taken by the author in the preparation of this information, the author and InvestmentMarkets (Aust) Pty. Ltd. as publisher take no responsibility for any actions taken based on information contained herein or for any errors or omissions within it. Interested parties should seek independent professional advice prior to acting on any information presented. Please note past performance is not a reliable indicator of future performance.