The Financial Race
Imagine you are in a race. The starter pistol goes off and you start running towards the finish line. At some point, you look up, and to your horror, you see the finish line moving away from you. As if that’s not bad enough, you realize it’s moving away faster than you are moving towards it.
In other words, even though you are running as fast as you can, you are losing ground relative to the finish line. Your first thought is “I didn’t know the finish line would be moving.” Your second thought is, “I need to find out how fast the finish line is moving away from me.” You realize you have to start running faster than the finish line is moving away, otherwise you will just keep losing ground.
Measuring Your Progress
You spend your entire life working hard, believing you are moving towards your financial goals when in fact, you are falling behind. It turns out you can measure exactly how much you are falling behind.
The finish line in the “race” represents your financial goals. Your financial finish line is being pushed away from you everyday by forces in the financial system, such as taxes, inflation, and interest. Of these three, the biggest is inflation, which is also the one that people don’t account for correctly in their financial plans.
As a result, your chances of ever reaching your financial goals get smaller and smaller every day.
The Secret Formula
In the late 1990s, I worked at Intuit Corp as a software developer on a number of their FinTech products, one of which was Quicken Financial Planner (“QFP”).
QFP helped users track their progress towards retirement planning by offering “what if” scenarios and simple step-by-step functionality. As you can imagine, the software used a multitude of complex formulas.
One day, I discovered an extremely powerful formula embedded deep in the code. It turns out this is the universal formula that ties all investments together and is the defining calculation that shows you whether an investment is moving you toward your financial goals.
It is called the “Breakeven Formula” and I immediately realized people needed to understand and begin using it in their financial planning.
Unpacking the Breakeven Formula
To help you understand the power of the Breakeven Formula, think about your own investment portfolio. Chances are you own your home along with some other assets like stocks, bonds, mutual funds, and maybe even some rental properties.
You may believe you have the assets needed to reach your financial goals. Year over year, your assets are appreciating making it look like you are building wealth. But are you really? Even though your portfolio is appreciating in value, financial forces like inflation are eroding your purchasing power faster than your portfolio is appreciating.
The Breakeven Formula calculates the rate of return your assets need to generate in order to beat financial forces such as inflation. Said another way, the Breakeven Formula tells you how fast you need to run in order to reach your financial goals and how fast the finish line is moving away from you in our “race” above.
The Breakeven Formula calculates the “Breakeven Rate” (also referred to as the “Breakeven Return”) that will tell you how FAST your finish line, or defined financial goal, is moving away from you.
Let’s plug in some numbers to illustrate the Breakeven Formula in action.
| Tax Rate: (Get from your accountant) | 30% |
| Inflation Rate: (Calculate from Bureau of Labor Statistics) | 8% |
| Breakeven Rate: | (Result) |
In this example, let’s assume an effective tax rate (R) of 30%. When you calculate the Breakeven Return for your own portfolio, reach out to your accountant for your exact rate.
Additionally, we have used an inflation rate (I) of 8% for illustration purposes. You can find the current government published inflation rates at this link.
Let’s plug those numbers in:
Breakeven Rate
11.43%
You can calculate your own Breakeven Rate using the calculator above. In our example, the breakeven rate is 11.43%. But what does this mean?
It means that your whole portfolio needs to generate an 11.43% return every single year just to maintain your purchasing power. This is without using debt and before accounting for taxes and inflation.
Think about your current portfolio. Are you generating 11.43% returns consistently year over year? Every year you miss your target, the finish line moves further away from you.
The Breakeven Return (11.43% in our example) is the speed at which the finish line is moving away from you in our race analogy. If your portfolio returns (speed) are anything less than your Breakeven Return, you are moving backwards financially. But it gets worse. Even though you are losing purchasing power every year, you won’t feel the impact of that “lost ground” until you retire, when it’s too late.
Over time, as your portfolio does not generate the required returns, your purchasing power erodes, leaving you unable to maintain the lifestyle for which you have worked so hard.
