Last week I discussed research showing the correlation between wealth and education. The Federal Reserve followed up with additional research about wealth and demographics, the subject of this post. More specifically, wealth and age. Not surprisingly, the older a household is the more wealth has been generated since people have had more time to save and invest. There is some very good advice that comes from the research, however, which discusses the optimal management of one’s assets and liabilities.
Older Families – Personal Wealth Common Sense Recommendations
Here are some common sense recommendations about household and personal balance sheets offered up by the authors:
- Greater balance-sheet liquidity can support greater wealth accumulation over time by buffering a family against financial shocks, which can lead to high-cost borrowing, distressed asset sales, or costly default on debts and other obligations;
- Greater asset diversification-including high-return assets like stocks or a small business can lead to greater wealth on average over time due to lower volatility for any given level of expected return on assets (or equivalently, a higher expected return for a given level of volatility), reducing the likelihood of encountering costly financial distress; and
- Lower leverage (debt-to-assets ratio) can lead to greater wealth on average over time both because borrowing itself is expensive and because balance-sheet leverage amplifies any shock to a family’s asset values into larger percent changes in net worth, raising the risk of insolvency and of costly default on debt or other obligations.
Notice that all of the suggestions are designed to create a large margin of safety to handle financial shocks and to lessen the chance of them happening through proper diversification and debt management. We try to follow this advice in how we manage our investments and business at CWS as well as in my personal life.
Here are some of the quantitative differences in some of the key metrics in terms of measuring financial safety.
Older families typically have more liquidity than middle-aged or young families. The median holdings for each in 2013 were as follows:
The percentage of financial and business assets were as follows in 2013:
Finally, older families are far less leveraged than younger ones as measured by the median debt-to-assets ratio:
Older: Essentially 0%
Middle-aged: 25.3% (up from 14.2% in 1989)
Young: 44.9% (up from 34.4% in 1989)
Older families got to where they are today by saving during their peak earning phase in middle age as well as because of prudent balance sheet management by building up cash reserves to cushion against a financial setback. In addition, they have tended to diversify beyond housing and durable goods into financial and business assets.
While the authors don’t know whether middle-aged and older families are wealthier because of their greater diversification and debt choices or having greater wealth leads or cause them to be better diversified and less leveraged, they suspect it goes both ways. They do make an interesting assertion, however, which has implications for apartment owners like CWS. They discuss bringing to the forefront the need for young families to accumulate wealth more rapidly and use the example of delaying home purchases. The authors suggest for consideration:
“to delay purchase of a home with its attendant debt burden until it was possible to buy a house that did not make the family’s balance sheet dangerously undiversified and highly leveraged.”
5 Questions to Predict Wealth Accumulation – Financial Health Scorecard
Another great addition to the article is the inclusion of a Financial Health Scorecard to predict wealth accumulation. It consists of five questions and each one is scored with a one or zero with the maximum score being five. A one increases financial health and a zero detracts from it. The questions are as follows:
- Did you save any money last year?
- Did you miss any payments on any obligations in the past year?
- Did you have a balance on your credit card after the last payment was due?
- Including all of your assets, was more than 10 percent of the value in liquid assets?
- Is your total debt service (principal and interest) less than 40 percent of your income?
This survey has been carried out between 1992 and 2013 involving 38,385 families. The average scores were as follows between 1992 and 2013:
All families: 3.01
Older: 62 or older 3.46
Middle-aged: 40-61 2.88
Young: Under 40 2.82
Clearly the older families have shown the highest average financial health over the 22 year period which is not surprising given their stronger balance sheet and liquid assets. This is a great scorecard for all of us to follow to improve our accumulation of financial assets over the years and to help lessen the probability of a financial issue sinking the ship.
Over to You:
How is your financial health scorecard? In the example above, did you have more zero’s or ones?