End of financial year is the perfect time to reflect on your financial progress—but it’s not just about net worth.

In this episode, Mark and Shani share how to review your portfolio properly, using key metrics that reflect real progress toward financial independence.

From savings rate and passive income to your required rate of return and even peace of mind, they walk through how to track your journey—and make sure your money is helping you build the life you want.

Topics covered:

  • Why net worth can be misleading
  • What “real wealth” actually looks like
  • The power of a high savings rate early in life
  • Passive income ratio and replacing employment income
  • Debt-to-income and liquidity as freedom metrics
  • How to calculate your required rate of return
  • Why peace of mind might be your best indicator of success

You can find the full article here.

Listen on:

Get Morningstar insights in your inbox

You’re able to find the transcript of the episode below:

Mark LaMonica: Welcome to another episode of Investing Compass. Before we begin, a quick note that the information contained in this podcast is general in nature, does not take into consideration your personal situation, circumstances, or needs. So, Shani, you have been immersed in the world of font and colors, and I guess that’s it. You’re trying to pick out the cover for our book that’s coming out soon.

Shani Jayamanne: We’re both trying to pick one out.

LaMonica: I know.

Jayamanne: But I’m a bit more picky.

LaMonica: You’re more picky, plus I’m color blind, which makes it challenging for me. But the other exciting thing is we have a release date now.

Jayamanne: We do, October 6th.

LaMonica: Yes, which, you know, that’s a public holiday.

Jayamanne: Oh, well.

LaMonica: At least in South Wales it is.

Jayamanne: So people have time to go out and hit up their local bookstore.

LaMonica: I mean, I’m just imagining when I walk down George Street, sometimes there’s these giant lines outside of the Nike store. So I assume they’ve released new sneakers.

Jayamanne: You think that’s going to be our book.

LaMonica: Nationwide outside of bookstores.

Jayamanne: Well, let’s see how it goes.

LaMonica: It’ll be exciting. You can show up.

Jayamanne: It’ll be because of the cover.

LaMonica: It will. It will. But you’re not really supposed to judge a book.

Jayamanne: By its cover.

LaMonica: So what are we doing today?

Jayamanne: Today, we’re going to talk about a portfolio review and how to measure your progress.

LaMonica: And we’re doing this right now because end of financial year is a great time to do this because it’s a natural point of reflection. You get all of your investment and your super and your bank statements. So because you have all these annual statements, you get a snapshot of what’s happened over the previous year. And since all the information is available, you might as well sit down and check your progress.

Jayamanne: And it’s also when you do your tax return. And that gives you a good overview of your income over the last year. So you get a bit of a holistic overview.

LaMonica: You do your tax return. We’re talking about end of financial year, not October.

Jayamanne: October is when you do your tax return.

LaMonica: Yes.

Jayamanne: Okay.

LaMonica: I will say that when people do this, it’s obviously often tempting to look at the increase in your net worth from year to year. So how much you had last year, how much that’s changed in the past 12 months. And that is just obviously one yard stick. But we’re going to spend some time looking at how you can have a more holistic view of your finances and the progress you’re making towards building wealth.

Jayamanne: So a good place to start would be your net worth. And when we think about wealth and wealthy people, we’re often focusing on net worth. We see this all the time with rich lists and rankings of the most wealthy people. And really net worth is a good way to rank these people. But if you are nowhere near that level of wealth, we think there are other things that you should focus on.

LaMonica: And we think a real measure of wealth for most people is the ability for your resources to make a meaningful difference in your quality of life. So net worth is obviously important because it’s a long-term indicator of your ability to build wealth. But the issue with just looking at your net worth is that it’s often just this paper figure. So a large portion is typically tied up in liquid assets, which often involves a lot of debt. So specifically, we’re talking about housing. And in Australia, 67% of total wealth is in property. And a lot of that’s also carrying a mortgage.

Jayamanne: And there does need to be an exit plan for assets. Net worth is only really useful when you can realize gains and use that wealth to improve your life, especially if your investments are cash-flow negative. So that’s what we’d classify as real wealth.

LaMonica: And it’s very easy for individuals to obsess over this net worth figure. And we see it all the time on social media. And people make these statements. I’ve amassed $3 million by age 30. And that’s a great achievement, but it doesn’t really contain any of the disclaimers that you need for building that wealth. So that could be a healthy amount of debt that’s included. It could be funds locked up in super until you’re 65. It could be depreciating assets, like people count motor vehicles in this. It’s just not really a reflection of the quality of life or the financial strength that people have.

Jayamanne: And this obsession with net worth can also drive poor decision making. Imagine the market is running and you hear about how all these speculative investments are earning huge returns. You’re more inclined to chase them because you have a short term focus on your net worth. When the market is falling and you’re fixated on your net worth, you’re more likely to sell to stem the flow.

LaMonica: Okay. So we’re going to try to come up with a better way, Shani. So we’re going to go through some ratios to measure progress towards building wealth and our definition of wealth, where it enables a better life. And ratios, of course, are fine for providing context during a portfolio review, but having a quantified goal for what you’re trying to achieve and focusing on a required rate of return, which we talk about a lot on here. And that is the return that you need to achieve your goal. We think that that’s a really sensible approach. But it can, of course, help to take a step back and focus on what you are worth on paper and comparing that to what you need to achieve a financial goal. So we’ll go into that in a little bit. So let’s start with the next indicator. And I know this is one that you love, Shani, and it’s what’s your savings rate?

Jayamanne: That’s it. So for those earlier in their wealth building journey, savings rates are also really critical. High income earners often focus on how much they earn and not only how much they’re keeping and people do underestimate how powerful a high savings rate is early in life. And it really does compress the timeline to financial independence.

LaMonica: So if you’re saving 50% of your income, which is not easy to do, what that basically means is you only need to fund one year of lifestyle with one year of work. And that’s a pretty powerful mindset shift to think about savings in that way.

Jayamanne: And as Mark said, personally, I do really like to place a large focus on savings rates in my own investment strategy. And I try to focus on what I can control. If I’m contributing $100 a week to my investments, then I managed to save an extra $10. That’s effectively a 10% return. Managing your savings rates and making sure it’s sustainable over the long term can supercharge your wealth creation.

LaMonica: Okay, let’s move on to the next one. And that is cash flow. So year on year cash flow. And this is really looking at what we would consider real wealth. So most of us live on a cash flow basis. So income comes in, expenses go out.

Jayamanne: And we’ve done a whole episode on why Mark focuses on cash flow and why it’s what he focuses on.

LaMonica: A much ridiculed episode by you.

Jayamanne: It wasn’t ridiculed. So you can go and listen to that on why you choose to focus on cash flow. And it’s called Cash Rules Everything Around Me. And again, I think we’ve talked about this in recent episodes, but that was when we were trying to be very clever with our titles. And we’re using lyrics from Drake and Jay-Z.

LaMonica: Okay, you, when I saw this, do you know what that actually comes from?

Jayamanne: Well, I named the episode and I named it off a sample from a Drake track. And I know like it originated somewhere.

LaMonica: Wu Chang.

Jayamanne: So anyway, we don’t quote Drake anymore on this podcast.

LaMonica: Shani is officially done with Drake. So anyway, yes, Shani did ridicule me for this episode, but I think cash flow is really, really important. I think it’s an important concept for people to think this way. So wealthy people shift from earning wages to being paid by their investments. Instead of tracking asset value, they track the income those assets generate. So that could be dividends, it could be interest, it could be rent received on an investment property. And tracking how much income your assets produce is one way to measure progress towards financial independence. Another is tracking how close you are to replacing your employment income, which really, for many people, I think is the definition of financial independence that you no longer, whether you choose to work or not, you no longer need that employment income to live. And yes, I think that passive income, something I talk about a lot, a really useful ratio is what we would call passive income ratio.

Jayamanne: And being able to compare your cash flow year on year will give you an understanding of how close you are to closing that gap between your lifestyle and your portfolio. So the narrower it gets, the more choices that you do have.

LaMonica: Okay. Our next indicator is debt to income ratio. And a debt to income ratio compares your debt payments to your income. So it helps you understand how much of your income goes towards repaying debt. But over time, it indicates if your income is rising and you’re paying down debt, hopefully that ratio is getting better. So ultimately what that is, it’s a reflection of cash flow that you can choose to spend instead of going to repay debt and just the liquidity you have in your life increases when that happens.

Jayamanne: And many definitions of debt to income describe it as comparing your debt payments to your gross income. But I think we both prefer to compare it to net income. Comparing it to gross income is pretty misleading. How is the comparison to your income prior to removing your super, your tax and student payments to the ATO are helpful? And you really want this comparison to be debt to net income.

LaMonica: Yes. And Australians, I looked at this yesterday for something that I’m writing. So if we look at debt to income, Australians are third in the world.

Jayamanne: Who’s beating us.

LaMonica: Like not in a good way. I forget the second country, Switzerland is one of them. There’s one other European country. I forget what it is. But that’s not really the third in the world makes it sound like it’s a good thing, but it is not.

Jayamanne: You don’t really want the bronze for that.

LaMonica: Exactly. But I’m confident Australia can get to the top. All I think we need is some more property price appreciation and stagnant wages. And Australia can be at the top, the top of the table. And I think obviously one of the reasons is that Aussies typically hold a lot of mortgage debt, but then there’s also consumer debt. And so when we’re going back to that original indicator, two variables in this ratio, of course, are debt and income. So a decrease or increase respectively indicates that you’re in better financial position.

Jayamanne: And let’s speak about liquidity for a moment, which is a direct result of debt reduction. Liquidity is sometimes called runway.

LaMonica: Exactly. And again, wealth buys freedom and flexibility. Having liquid assets gives you the ability to make lifestyle choices. So a good starting point is another thing that you are a huge proponent of, to be fair, where most people are, an emergency fund. It of course provides you with peace of mind and lets you deal with any unexpected circumstances in your life.

William Ton: I’m Will, producer of Investing Compass, and here are this week’s must reads on Morningstar.com.au. Mark’s Unconventional Wisdom column takes a deep look at the state of housing in Australia. He explores whether housing is the anchor weighing Australia down. Mark explains why he think it is and how the cost of housing is sapping the economy, lowering living standards and hampering our financial independence.

This week, Shani’s Future Focus column focuses on traditional metrics for understanding whether you’re wealthy or whether there are better ways to assess your progress towards wealth creation in your end of financial review. She runs through the ratios that you can use during your portfolio review and conduct a holistic assessment. Joseph’s featured article this week takes a deeper look at the deeper value style of investing. He explores what it involves, potential opportunities and drawbacks for individual investors, and where a high profile manager that follows this approach is finding ideas today. The article also reveals the most interesting stock pitch that Joseph heard at Morningstar’s recent investment conference for financial advisors in Sydney.

ETFs have gained massive investor popularity over the last five years. It’s safe to say that all the investors are a little obsessed with the product. And why not? With instant diversification at relatively low cost fees, no one can argue that they are an attractive product to build wealth. But is there anything we might be missing from this one-track fixation? Sim explores some of the potential drawbacks associated with ETF investing and evaluate how these may affect investor assumptions about the safe investment. These articles and more they are now available in the show notes. And let’s get back to Mark and Shani.

Jayamanne: Is there anyone that you think really does not like an emergency fund?

LaMonica: Well, since a lot of people don’t have that, maybe it’s the majority. I think a lot of people just based on their behavior do not like saving money. But emergency fund is obviously one very specific part of this liquidity equation we’re talking about. But I think a broader liquidity buffer does more. So it not only protects you from emergencies, but it also positions you to be able to take advantage of opportunities.

Jayamanne: So let’s say you’re someone who owns multiple investment properties. On paper, your net worth is substantial because these properties have grown in value. But you’re servicing multiple mortgages and relying heavily on your employment income to do so, and it can be limiting. So for example, if a dream job opportunity comes up overseas, it requires a pay cut. Your options are very limited. You’re tied to your assets and that limits your freedom.

LaMonica: And having this liquidity runway, it means that your assets are not locked away. They’re not locked away in illiquid assets. Gives you flexibility, allows you to make lifestyle choices. So having lower debt obligations allows you, of course, to build up these liquid assets. And it gives you that freedom to make decisions about what you want in your life. And we think that that is true wealth. And there is, of course, an opportunity cost of holding cash. We talk about all the time that, you know, think through your plan, how much cash you’re going to hold, because the opportunity cost is that shares have historically performed a lot better as well as other asset classes. So we certainly aren’t saying you should just hold cash here. But I think it’s really important to think about what you want out of life and design that asset allocation around your goals and around what you want to achieve.

Jayamanne: Okay, so we’re going to move on to required rate of return. This is less about wealth and more about whether you’re on track to reach your financial goals. And it’s about your progress on the road to building wealth, as people do not build wealth for building wealth’s sake. So they really just build it to achieve the life that they want to live.

LaMonica: Okay, so we’ll go through. We’ve done this a couple of times, but we’ll go through required rate of return. So in order to know your required rate of return, you have to go through the process of quantifying your financial goals. So you need a number. What will your goal cost? And you need the time that you want to achieve that. And what the required rate of return is just the difference between those two, incorporating your savings as well. So that return is the annual return that you need to achieve to get from where you are to where you want to be. And obviously, we want to incorporate inflation into this because your goal will probably cost more in the future.

So we do want to incorporate that. But let’s go through an example of why this can be so valuable. So a lot of people will look at their portfolio, the returns they get, the net worth, everything we were talking about, but there’s no context to any of that. So if you know that you need a 6% annual return to reach your goal, let’s say of a house deposit in five years, then when you’re going through this review, you can look at what your actual return is. So if you saved extra this year, like you were talking about Shani trying to control what you can control, then all of a sudden that 5% annual return might have dropped to 6%, might have dropped to 5%. And so that’s improved the chances that you’re going to reach your goal. So we think that required returns great to add context to investment returns and your overall net worth increasing.

Jayamanne: And the last thing we’ll say here is that context is required for these indicators, as well as the metrics. It’s important to understand how these figures impact you. Everyone is different. Some people are risk seekers and don’t mind being leveraged to the hilt. Others feel extremely uncomfortable with debt. The unfortunate fact of the matter is that many households in Australia that are looking to build wealth and have taken on a mortgage experience, what we would call mortgage stress. It’s when more than 30% of pre-tax household income goes towards a mortgage. And the unfortunate part of this is that with price of housing in Australia, many don’t have a choice if they want to own their own home.

LaMonica: And this arbitrary and arbitrary metric also is not taken into consideration, whether you earn a household income of $200,000 or $2 million. You could still be dispensing 30% of your household income, but both scenarios have vastly different outcomes in terms of the potential savings rates, emergency buffers, and debt to income. So part of a portfolio review or reset is reflecting on not just the metrics or ratios, but also what kinds of financial situations cause you stress.

Jayamanne: And lastly, I think there’s one underappreciated indicator of progress, and that’s how you feel about your financial situation. For me, the most underappreciated indicator of an improving financial situation is peace of mind. Do you think less about your bills and your obligations, more Australians are experiencing financial stress and anxiety due to challenging market and economic conditions? So it’s not one that most people acknowledge, but building financial freedom often means that you are improving your quality of life and not just the life that you’re able to afford, but the mental security it affords you.

LaMonica: And when you’re looking to build wealth, there’s no one indicator that’s better than others. The goal should be to reach a place where you have both long term investments that build your net worth and accessible liquid assets that give you freedom of choice and peace of mind, as Shani said. That’s what real wealth looks like. When we look at wealthy people with large asset bases, they are able to do both. So high net worth is naturally required to have a sustainable recurring passive cash flow. However, high net worth doesn’t always translate to a better quality of life or financial freedom if everything’s tied up in liquid assets. So those assets must either be sold or disposed of in some way to realize those gains and enjoy those gains to improve your life.

Jayamanne: And these indicators can be useful to track your progress to financial goals, but it’s always important to remember that investing is a means to an end. Ultimately, wealth is about choice and giving yourself options and independence. So it is important to reflect whether your investment strategy and assets are contributing to this.

LaMonica: All right, great. So that’s our episode. One thing to check when you’re looking at your net worth is if you have enough to buy our book, right, Shani?

Jayamanne: Agreed.

LaMonica: All right. Thank you guys.

Jayamanne: Several.

LaMonica: Several books. Thank you.