If you ever talk to MBA’s (especially those into finance) you will hear them wax eloquent about a company’s capital structure. Capital structure is nothing but how a firm finances itself. Firms need money to operate. How do they get that money? They have a couple of choices – just rely on the profit they generate, issue shares to investors (issue equity) or borrow money from investors (issue debt). The choices that a firm makes and the mix of self financing vs equity vs debt is what is termed as the capital structure of the firm. Having a structure formalizes things, makes company profitability easy to analyze, brings predictability.
So how does this affect you?
You can use the same framework for your personal finances. Your household/life is exactly like a firm. You produce revenue (based on a job), and you spend (expenses) on things that matter (like life :)). You have a couple of choices on how you want to fund your life. Do you want to do it finance only via profit? (The difference between what you earn (revenue) minus what you spend (expenses) equals savings. Savings are your profits) or do you want to finance via debt (mortgage, credit card debt)? or a combination of both?
What is the best capital structure for your life?
Some thoughts follow. Strong disclaimer: These are personal opinions and is not indicative of a process that works for everybody. Please consult your financial advisor before implementing any changes in your life. The assumptions are for a 25-35 year old. Don’t sue me ok? 🙂
Before constructing on a personal capital structure, you should align on a few core principles and goals.
Your goals should be:
- Maintain an appropriate risk/reward ratio. i.e take the least amount of risk for a certain reward.
- Have a long investing horizon. i.e you don’t need your invested money in a short time frame (8 -10 years).
- Sleep easy at night and not worry about day to day financial swings.
The long investing horizon is a biggie. Research has repeatedly shown that investors who trade in and out of investments tend to lose the most money. Individual Investors cannot time the market and somehow always end up buying high and selling low. If you have a long time horizon you can afford to not react to short term swings in the market.
With these goals an ideal capital structure could be:
- Cash : 4 years of living expenses OR 15% of net worth (whichever is bigger)
- Real estate (house) portion you own: 15% of net worth
- Investments : 70% of net worth
- Stocks : 55% of net worth
- Bonds : 15% of net worth
- High interest debt : Zero
- Medium interest debt (mortgage): less than 30 % of net worth.
An adequate cash balance is the fundamental pillar of this model. Having a good cash buffer has a lot of advantages. First and foremost, you are better prepared for uncertain emergencies. With today’s high employment rate, a good cash buffer is prudent. This also enables you to pursue a long time horizon strategy for your investments as you have your day to day life covered. Cash is truly king :). By adequately controlling your low-med interest debt (mortgage) you are making sure that you have manageable leverage in your household. You want to be able to ensure that you are able to cover debt payments for a while in the event of an emergency. By following a capital structure model, you now have a process that helps you sleep better at night!
If you are in a bind and don’t have the cash/assets lying around to get to this optimal structure, fear not! there is a way!
- First save up enough cash for 2-4 years of living expenses.
- Next, divert all excess cash to paying down high interest debt.
- Finally divert further excess cash into investments.
What do you guys think? How do you guys manage your personal capital structure?
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