Kim Snider
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November 06, 2006

Cash Flow the Best Measure of Wealth

I would like to share with you an excerpt from the November 2, 2006 edition of John Mauldin's Thoughts From the Frontline newsletter. As I have said elsewhere, if you don't already subscribe, you should. It is one of the most cogent letters out there. Which is why it goes out to over two million readers each and every week I am sure.

 

In this week's issue, titled "The Return of the Muddle Through Economy", John includes a summary from Rob Arnott in the Financial Analysts Journal on wealth:

 

What Is Wealth?

 

"How we define wealth," says good friend Rob Arnott, "or investment success, drives our approach to investing. Benjamin Graham was fond of saying that the essence of investment management is the management of risks, not the management of returns. Well-managed portfolios start with this precept."

 

Writing in this month's Financial Analysts Journal, Rob gives us a different way to look at wealth. (Rob, besides successfully running billions of dollars at various funds, is the editor of the FAJ and has given me permission to use this material.) Quoting:

 

  • "Can we measure our wealth as the value of our portfolio? Hardly. Today, $1 million buys much less than it did 25 years ago.
  • "Is wealth defined by the real value of our portfolio? Only if we plan to spend it all right away.
  • "Is wealth the long-term spending that our portfolio can sustain--the annuity that our assets could procure? This definition is closer to the truth, but like the first, it ignores purchasing power.
  • "Is wealth, then, the inflation-indexed real income that our assets could sustain over time? For most investors, this is probably the most useful definition of wealth."

 

But what assets should we invest in to get the best inflation-indexed returns? Stocks? Bonds? Commodities? And what about the risks of these various asset classes? In a very interesting study, Rob redefines risk not as volatility of the asset class in terms of price but in terms of real sustainable spending. And he defines returns as not just a simple return, but as the growth in the real spending stream that the portfolio can sustain.

 

It's all about cash flow, or about the cash flow an asset or business can maintain. Real estate can produce a stream of income. Stocks can produce dividends or can be sold and invested in an annuity. Bonds pay an income. Entrepreneurs strive to build a business income model that does not solely depend on their continual involvement. (If you can't walk away and the business still produce an income, or if you can't sell the business to someone for cash to invest, you have a job, not a sustainable business.)

 

As investors, what we are ultimately concerned with should be future streams of income or cash flow. We work to get our portfolios to grow faster than inflation, and to enough size to support our desired lifestyle. But Rob is suggesting that it is not the size of the portfolio, but the ability to produce a sustainable long-term lifestyle.

 

Normally we think of T-bills as being the most risk-free investment. When viewed in terms of sustainable spending, however, T-bills become riskier than TIPS (inflation-adjusted bonds) and/or a regular bond portfolio. Look at the chart below. It represents the sustainable spending risk-adjusted returns of various asset classes. The red line is drawn between T-bills and stock market returns (as represented by the S&P 500). This is the classic capital market line between the "risk-free" asset and risky stocks.


Whatiswealth

 

Surprise. What you find out is that almost all asset classes produce a return or alpha higher than does the classic capital market when your define risk in terms of sustainable spending.

 

 

This is the point I have tried to make so many times and in so many ways. When your ultimate objective is income, traditional investments are not ideal - far from it. That idea is a throw-back to the days when all investments by the individual were essentially risk capital.

 

That is no longer the case. It hasn't been the case for almost twenty years. Unfortunately, we have been slow to recognize that fact and it isn't until we see the outcome for the retiring Baby Boomers that this reality will hit home. By then, in my opinion, it will be regarded as obvious but too late for tens of millions of Baby Boomers who were erroneously taught to focus on accumulation and capital appreciation instead of cash flow.


The way to measure performance is not the growth in the account value but the growth rate of the cash flow produced by a portfolio. If that cash flow is sufficient to sustain a decent standard of living, and is growing faster than inflation, then and only then do you have the ability to enjoy a sustainable standard of living indefinitely into the future.

 

My thanks to Snider Investment Method™ alumni, Shel Travis, for giving me the heads up on the John Mauldin newsletter.

 

If anything in this post inspires you to agree, disagree or ask questions, please feel free. You can leave your comments below.

 

SOURCES:

 

1. John Mauldin, "The Return of the Muddle Through Economy," Thoughts From The Frontline Weekly Newsletter; 2 November 2006. (subscribe here)

http://www.frontlinethoughts.com/pdf/mwo110406.pdf

 

 

Kim Snider, Kim Snider Financial Communications, Chronim Investments and/or Snider Advisors make no representation that the information and opinions expressed are accurate, complete or current. The opinions expressed should not be construed as financial, legal, tax, or other advice and are provided for informational purposes only. Call 866-952-0100 to request the Snider Investment Method™ Owner's Manual, which includes a description of the Snider Investment Method, investment objectives, risks, suitability and other information. Please read and consider carefully before investing. All investments are subject to risk including possible loss of principal.

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Cash flow is the driver of business value. Thanks to Kim Snider for her post titled Cash Flow the Best Measure of Wealth. In this post, Kim quotes extensively from John Mauldin's Thoughts from the Frontier newsletter. Mauldin writes on... [Read More]

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Kim Snider is an author, speaker and host of Financial Success Coaching, Saturdays at noon, on KRLD Newsradio 1080, Dallas - Fort Worth. This blog is primarily devoted to empowering individual investors with information to help them be good stewards of their money. Above all, it is about achieving true financial success. Kim's book, How To Be the Family CFO: Four Simple Steps to Put Your Financial House in Order is in bookstores now. Order yours from Amazon or other fine booksellers today.

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