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Michael Pope Blog post by Michael Pope

Another look at Predicting the Future

In a previous article, we discussed one of the key factors in developing a long-term wealth building strategy  –  the need to “predict”, or at least make assumptions about, how key variables affecting the outcome of the strategy will change in the future.  For example, a strategy involving the use of borrowed money will need to include an assumption about future levels of Interest Rates, a strategy involving investment in Shares will need to include assumptions about future share price movements and dividend yields, and most strategies will need to make assumptions about future rates of Income Tax.

But there’s another key variable that needs to be taken into account when planning a wealth building strategy, and that is the amount of money that will be required to be contributed on an ongoing basis to fund the strategy.  In some cases, a wealth building strategy may take the form of a “set and forget” investment, where an asset is purchased and no further money is required to be contributed.  But in many cases, the purchase of an investment asset is funded with borrowed money ( using “leverage” as discussed in an earlier article ), and this means that there will be Interest payments to be made, usually on a regular basis, until the debt is repaid.  There may also be other ongoing costs, such as management fees.

Depending on the nature of the investment, money to cover the ongoing costs may come from the investment asset itself, in the form of Dividends from a Share Portfolio, or Rental Income from an Investment Property, for example.  In many situations, however, the Income from the investment will be insufficient, particularly in the early years of the strategy, to cover the ongoing costs, and the shortfall will be made up by the investor.

 

And this is where predicting the future takes on a whole new dimension.

Not only will it be important to anticipate the amount of money required to fund the investment, which will require assumptions about the future values of factors including Interest Rates, costs of Asset ownership and Asset Yields, but it will also be essential to look at the amount of money that the investor has ( and will have ) available to meet the costs.

This opens up a wide range of additional factors which need to be considered, both in terms of current cash flows and in terms of how these cash flows are expected to change over the term of the investment strategy.

To be able to understand the amount of money that will be available to meet the ongoing costs of an investment strategy, an investor must consider all existing and future household cash flows and how these may be expected to change over time.

This includes some obvious factors such as income from salary or wages, regular payments such as Rent or Mortgage repayments, regular bills such as Rates, Gas, Electricity, Water, Insurances, etc., and other household spending such as groceries, clothing, vehicle expenses, etc.  To be able to identify the amount of money available to fund an investment strategy, all items of income and expenditure need to be identified or estimated and the calculated difference of income over expenditure gives the amount of surplus cash flow available, based on current levels of income and expenditure.

The next step is to look at these cash flows, and make assumptions about how they will change over time, so that an estimate can be developed of how the amount of surplus cash flow will change.  The final step in identifying available surplus cash flow is to look at any major one-off or continuing spending that will be required ( or desired ) in the future.  This could include things like new cars, school fees or major holidays.  It is essential to identify these in advance to ensure that when the time comes, there will be enough money available to pay for these major purchases and still be able to fund the planned investment strategy.

Empower Wealth’s Personal Wealth Management Program includes a sophisticated Personal Financial Fact Find to assist with recording all items of current and planned household cash flow and a Wealth Projection Simulator which allows you to model the effect of changing cash flows over time, together with many other factors which influence the long term financial outcome of an investment, to give you the numbers you need to make an informed decision about your financial future.

If you would be interested in seeing how these tools and techniques could be applied to your own personal financial situation, please come and see us for a free one hour consultation.

 

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