By Dr. Jim Dahle, WCI Founder
Becoming financially literate means acquiring a very useful body of knowledge. Possessing this body of knowledge is such a rare phenomenon in today's world that having it, especially when combined with some financial discipline, is like a superpower. When I speak, I frequently demonstrate the importance of financial literacy with a section of the talk entitled “Numbers You Should Know”. Today, I want to hit on seven financial numbers that you should know. As we go along, I want you to look at each number and then BEFORE reading the paragraph below it, explain to yourself why the number is important. The more of these you know, the more financially literate you are. If you get a perfect score, we could really use your help on the WCI Forum, the WCI Subreddit, and the WCI Facebook Group answering questions!
1%
Our first financial number you should know is 1%. Why does it matter? It generally matters because it is considered by many to be the industry standard for investment management and advisory fees. The problem is that it is a pretty lousy way to charge for many things. For example, if you are only paying 1% of your assets under management a year for advice and service, and your portfolio is only worth $10,000, that advisor is going to go broke trying to serve you for just $100 a year. Meanwhile, someone with a $10 Million portfolio is paying $100,000 for that same service, which is at least 10X too much! The point of knowing this number is that you need to have the ability to convert AUM fees each year to a flat fee and then compare the cost paid to the value received to ensure you are still paying a fair price.
1%
Okay. I cheated. I used the same number twice. 1% is also a rule of thumb in the real estate investment world. Here, the 1% rule means that in order for a property to perform well you should be able to charge 1% of its value each month in rent. So a $100,000 property should rent for $1,000 per month. You want to be able to charge $5,000 per month for a $500,000 property. Like any rule of thumb, it isn't perfect, but it's not a bad place to start. It will help you realize that if you can only charge $800 a month for a $250,000 property that you are banking on serious appreciation in order to get a decent rate of return on the investment.
4%
4% is a big one. This one came out of the Trinity Study which asked the question “Historically what percentage of my portfolio, adjusted upward each year with inflation, could I have withdrawn each year in retirement and probably not have run out of money after 30 years?” The answer is about 4%, often called a “Safe Withdrawal Rate” (SWR). The greatest utility of the 4% rule is not a retirement withdrawal strategy, however. The greatest utility is to reverse engineer the equation to realize you need about 25X what you spend in order to be financially independent. That helps in goal-setting.
20%
20% represents my recommended savings rate. A typical high-income professional, like a physician, needs to save about 20% of gross income each year of her career in order to maintain her standard of living in retirement. The number is probably closer to 15% for a typical average Joe who has a longer career and will receive more relative benefit from Social Security. If you want to retire earlier, you need to save even more. This number does not include other savings goals such as college, a home downpayment, or a Tesla fund. The point of knowing this number is to encourage you to calculate your savings rate each year and increase it until it gets into the range you need to meet your goals.
35%
This is probably the hardest one on the list for you to know at a glance. That's because it really should be reported as a range of 25-50%. This number represents the percentage of a high-income professional's peak salary that you will need your portfolio to replace in order to maintain your standard of living in retirement. Many financial advisors use 70% as an estimate of what one will need in retirement, but that number is far too high for the typical high-income professional. Think about all of the expenses you have now that will go away in retirement: most of your income tax, all of your payroll taxes, all of your retirement savings, all of your work expenses, all of your college savings, all of your child-related expenses, your term life and disability premiums, much of your transportation expense, etc. The number will be different for everyone, but if you will run the numbers for yourself, you will likely find it is between 25% and 50%.
45%
This is another one from the real estate investing world. At times called the 45% rule and at other times called the 55% rule, this indicates the percentage of collected rent that will go toward non-mortgage expenses like maintenance, taxes, vacancies, management, utilities, and upgrades. Many new real estate investors get frustrated when they realize that despite collecting more in rent than the mortgage costs, they still have a cash-flow negative property. If they had understood the 45% rule, this would not have been surprising to them. If your mortgage costs more than 55% of the expected rent, you're probably not going to have a cash flow positive property. Either get a longer mortgage, put more money down, or find a better property.
72
The rule of 72 is a quick and easy way to tell how long it will take your money to double (in nominal terms) at a given rate of return. It demonstrates the power of compound interest. If you earn 10% on your investment, it will double in 72/10 = 7.2 years. If you earn 7.2% on your investment, it will double in 72/7.2 = 10 years. If you earn 3% on your investment, it will double in 72/3 = 24 years. You can also use this for debt. If your student loan is at 6.8% and you're not making payments, it will double in size over 72/6.8 = 10.6 years. A 29% credit card debt will double in 72/29 = 2.5 years.
The numbers in this post each represent a rule of thumb that is worth knowing and demonstrate your level of financial literacy. How did you do? Compare your score to the scale below:
0-1 You've got a long way to go. Keep reading the blog.
2-3 Nice work. You're paying attention.
4-5 Impressive. You are far more literate than most of your colleagues.
6-7 Come on over to the forums. We could use your help.
What do you think? What other “numbers” (rules of thumb) do you think a financially literate high-income professional should know? Comment below!
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