To Manage Your Finances You Need to Measure Them. But What Are the Measures?

Have you noticed that our schools taught us about writing, math, history, arts and science but surprisingly little about managing our finances? Yet in the life we live after our formal education ends, financial management becomes one of our highest priorities. It’s no wonder, then, that so many of us feel unprepared to plan for our financial future. Where do we even begin? Well, there is an expression: “In order to manage it, you need to measure it.” And that’s where to begin the Financial Management process – with measurement. Almost anything can be measured. For example:

• Academic performance can be measured by test results, class rank, or honors received.
• Your progress on a diet can be measured by calories consumed, pounds lost, or perhaps body fat percentage.
• Career success can be measured by job titles and promotions, salary, the financial (or environmental or social) impact of activities you were responsible for.

Sure, not everything can be measured precisely, and some measures are more appropriate than others. But applying even a rough measure is still better than having none, and doing so will almost certainly produce a better outcome. This holds true for virtually any activity. Why? Because measurement allows you to set a tangible goal. And you can then track your progress against the goal until it is achieved. Measurement Generates Results We see over and over that establishing a measurable goal generates results. For example, let’s look at retirement planning. According to a 2007 research study published in the Journal of Monetary Economics (1), “those who undertook any planning – even ‘a little’ – are much better off than those who said they planned ‘hardly at all.’” Specifically, those who planned a little had a median net worth of $173,400 compared to only $79,000 for those who planned hardly at all. And those who planned even more had even higher net worth. So, measurement is important. But what measures should you use for managing your finances? Well, that depends on what you’re trying to accomplish – it depends on your goal. If you’re focused on the short term, then perhaps debt reduction – paying off credit card or other debts – would be an appropriate goal. The measure for this would simply be the dollar amount of the debt you plan to repay. Those who undertook even “a little” financial planning had a median net worth of $173,400 compared to $79,000 for those who planned “hardly at all.” But what measures would be most appropriate for a longer term, strategic financial plan? Again, we need to establish a goal to help us determine the measure. So let’s work backwards and start with the destination. For most people, the longer term financial destination is a secure retirement. And a secure retirement requires sufficient financial resources for you NOT to have to work anymore to cover your cost of living. The most commonly used measure of your financial resources is net worth. That’s the measure used in the statistic cited above. Net worth is the sum of your household’s assets (all the things you own) minus all your liabilities or debts (all that you owe). So if you were to sell all your assets and use the proceeds to pay off all your debts, then whatever is left over is your net worth. Net worth is, essentially, a measure of your wealth. So you want to make sure you have sufficient wealth to cover your cost of living during retirement. But is net worth alone a sufficient measure to use for your long-term Financial Planning? In our next article we will address whether net worth should be supplemented with other financial measures. What do you think? We’d like to hear your thoughts.