8 Financial Vital Signs
Have you ever noticed that every time you go to the doctor, whether you’re healthy or sick, there’s always someone you start with who runs through the same basic tests?
They take your temperature, check your blood pressure, your pulse, and your breathing rate and they do this for every patient, every time they visit.
And, as you are probably aware, there are good reasons for them to run through these tests.
For one, they need to make sure you aren’t exhibiting any potentially dangerous symptoms, but they also need a baseline or starting point for your visit.
Your vital signs will inform the rest of the treatment you receive. Not only that, but if this is a physician that you visit regularly vital signs provide data that can be compared over time to spot any trends that could be good or bad for your health.
Well, there are several financial datapoints we can check on from time to time to help us identify and diagnose our own financial health.
Let’s walk through 8 of those vital signs now and quickly highlight a few others you can consider at the end of this post.
1) Emergency Fund Ratio
What it Measures: Amount of cash available for emergencies relative to normal expenses.
Equation: Liquid Cash Available / Average Monthly Expenses = Emergency Fund Ratio
Goal Score: Greater Than 3
In case you are unaware, the very earliest posts to martinmoney.com included a central component of our website, The Next Dollar Roadmap.
The Next Dollar Roadmap outlines, step-by-step, a general path for anyone to follow to financial independence.
The first milestone on that roadmap is a small emergency fund called an “Uh-oh Fund”. Its purpose is to simply keep you above water in the event you face a sudden, unexpected expense like a car repair or a medical deductible.
Just two milestones later, after employer matching and debt elimination, is a larger, fully-funded emergency fund we cleverly named the “Fully Funded Emergency Fund”.
Both the Uh-Oh Fund and the Fully Funded Emergency Fund are like life preservers in a boat. You probably don’t think much of them until you need one. Then they are invaluable.
In a financial sense, emergency funds allow us to absorb sudden shocks or setbacks without knocking us off track completely.
I recommend keeping at least three to six months of expenses in this fund so you can ride out a period of reduced income or heavier-than-expected expenses.
Naturally, to calculate the sufficiency of your emergency fund, you’ll need to know how much you normally spend each month because this will determine how quickly you burn through your reserved cash.
In the formula we’ve provided, simply divide your available liquid cash by your average monthly expenses.
For example, if you have $15,000 in cash savings and your monthly expenses are $5,000/month, then your Emergency Fund Ratio is 3.0.
Anything higher than this is good. Anything lower and you should consider stocking up a bit more cash.
Now to clarify, when I say cash, I mean anything that could be liquidated quickly with little to know concern over its value at that moment.
For example, savings accounts, money markets, and CDs are all examples of cash equivalents.
Houses, stocks, and even treasuries either take time to liquidate or they could be less valuable when sold if you had to liquidate them in an emergency.
Just like you wouldn’t put a fire extinguisher in a difficult-to-reach place, your emergency cash needs to be accessible.
Furthermore, if you are in a situation where you and your loved ones are depending on a single income or your income sees large fluctuations in reliability, you should consider increasing this ratio to 6 at a minimum and consider saving all the way up to a full year of cash.
Having unreliable or concentrated income calls for a higher margin of safety.
2) HAT Ratio
What it Measures: How much you’re paying for housing and transportation relative to your income.
Equation: Housing Costs + Transportation Costs / Income = Housing Ratio
Goal Score: 30% or lower
On average, Americans spend a combined 45% of their income on housing and transportation.
The good news is, on average, this leaves enough money each month for us to mostly cover other expenses like food, fuel, utilities, clothes, etc.
The bad news is this does not leave enough money available for building adequate retirement savings.
If you want to work forever, this is not a problem. But if you want to retire one day you need to make some difficult choices to do so.
In my opinion, one of the easiest ways to leave room for saving and investing a healthy portion of our income is to limit our expenses for housing and transportation as much as possible.
For one thing, we’re more likely to find success if we only have to extract it from one or two sources (as opposed to all of the other things we spend money on), but it is also much easier to hold our costs in these two categories steady if we make wise purchasing decisions.
For example, housing costs don’t change at all if you have a mortgage, and they probably only change annually at most if you’re a renter.
And car payments are normally secure as well, especially so if you don’t have any car debt at all.
So, just like it’s very easy to over-extend ourselves on these two items, it can be very easy to get our budget in line by using these two items wisely.
I recommend spending no more than 30% of your income on your cumulative costs for housing and transportation.
To calculate you HAT Ratio, simply divide your combined monthly housing and transportation costs by your monthly take home income.
So, if your monthly income is $7,000 and your housing and transportation costs are $2,000, your HAT ratio is 28.6%.
Now, I know there are many who scoff at the idea of having a HAT ratio below 30% because housing is so expensive in their area.
Well, first I’d point out that this is a combined housing and transportation ratio. If you want more house, then buy less car.
I’m also not completely against going a little over the mark here if you’re buying a first home and you expect your income to increase with time. If you’re close to 30%, the HAT ratio should eventually slip down into a healthy range.
As far as transportation is concerned, I am in no way endorsing car debt. If you don’t have a car loan please don’t interpret this as permission to go get one.
In my opinion, car debt is one of the single most destructive forces to personal finance there is.
If at all possible, and it should be for nearly anyone, pay cash for your next car.
3) Consumer Debt Ratio
What it Measures: The amount of consumer debt you carry.
Equation: Consumer Debt / Income = Consumer Debt Ratio
Goal Score: 0
You want to know a not-so-closely guarded secret about most millionaires?
They don’t have consumer debt.
“No kidding, Captain Obvious. They have enough cash that they don’t have to take on debt.”
Touché.
You want to know another not-so-closely guarded secret about most millionaires?
They didn’t have consumer debt before they were millionaires either.
The truth is avoiding consumer debt is a key step toward building wealth.
Just like you wouldn’t try to sail around with your anchor dragging the ocean floor, it’s difficult to imagine how anyone could expect to become wealthier while paying high interest to lenders.
There’s really not much to add here. Just say no to debt.
To calculate your consumer debt ratio, simply add up all your debts and divide them by your monthly income (or any income for that matter).
So, if you have $12,000 in debt and a monthly income of $7,000, your debt ratio is 1.71 which is much higher than zero.
To be clear, I don’t consider mortgages or student loans as consumer debt, but that doesn’t mean you shouldn’t pay them off.
I consider consumer debt to be debt that is issued against a depreciating asset. So think of appliances, cars, or nearly anything you’d buy with a credit card.
You’re much better off just avoiding these things altogether.
4) Saving & Investing Ratio
What it Measures: How much of your income you save or spend.
Equation: Monthly Saved & Invested / Monthly Income
Goal Score: Under 30, 15%. Under 40, 20%. Under 50, 25%. Over 50, AMAP.
I’ve already touched on the importance of saving and investing at least some portion of your income. Now I will explain why.
Simply put, your money needs time to grow. You cannot afford to wait to make investing a priority.
For example, here are the differences in value for an investment portfolio that receives a $100 contribution each month for 50 years with a 10% annual rate of return.
Compounding interest is incredible. Going back to the sailing metaphor, it is an incredible tailwind that can absolutely make you wealthy, but it takes time to work.
In this table, the returns take decades to generate real excitement.
I recommend saving and investing at least 15% of your portfolio if you start in your 20s, 20% if you start in your 30s, 25% if you start in your 40s, and as much as you can if you start in your 50s or later.
To calculate your saving ratio, simply divide the amount you save and invest each month by your monthly income.
If your income is $7,000/month and you normally save $800/month, then your saving and investing ratio is 11.4%. You should consider taking it up a notch unless you are a teenager.
For more about how much to save each month, check out this post about the percentage of your income you should save each month based on how far you are from retirement.
5) ROI Ratio
What it Measures: Actual annual returns vs. expected annual returns
Equation: Actual Annual ROI / Expected Annual ROI
Goal Score: Greater than 1
One of the challenges of selecting investments is there is no way to know how they will perform in the future.
This is also why I don’t bother trying.
For me, there is little reason to do more than invest in a cost-efficient, diversified basket of stocks through low-cost index funds.
In case you are unfamiliar with index funds, allow me to provide a quick explanation.
For many years, mutual funds were only managed by human fund managers who made investment decisions for the fund, according to the fund prospectus, for the benefit of the fund and its investors.
Their goal as fund managers is always to generate the greatest amount of return possible for the fund, according to its stated objectives.
Then, in 1975 John Bogle introduced the First Index Investment Trust which more or less tracked the S&P 500 market index.
The primary benefit of index funds is that they don’t require hands-on management from a human, which can also be quite expensive and erode the fund’s profitability.
Even though he wasn’t technically the inventor of the index fund, Bogle is largely responsible for making them what they are today.
Now that they have built some history, studies have shown that index funds outperform their actively managed peers around 80% or more of the time.
In other words, by following an index the management costs of the fund are reduced such that the end return for investors is higher than that of their peers.
This may be one of the more challenging ratios to calculate depending on what investments you are comparing.
I suggest researching the prospectus of the mutual fund you would like to investigate and search for an index fund that follows a similar strategy.
Next, find each fund’s stated returns and compare them for the same period by dividing the performance of the fund you own by that of a similar index fund.
You’ll also want to be sure that this state return includes expenses associated with the fund so you have a true comparison.
If the fund you own produces a higher return than your selected index competitor, you’re good to go.
For example, I compared Fidelity’s actively managed Large Cap Equity Fund (IICAX) with Vanguard’s Large Cap Index Fund (VLCAX) using their 2023 returns.
IICAX returned 21.7% while VLCAX returned 27.28%.
Frankly, I was expecting the index fund to win easily, but not that easily.
Anyhow, the ratio for this comparison is .795 which is quite a bit below our goal of 1.
I would sell IICAX in favor of a less expensive investment.
Speaking of less expensive, IICAX’s expense ratio is 1.79% compared to 0.05% for VLCAX.
I once wrote a post illustrating how just 0.90% difference in a portfolio could save you hundreds of thousands of dollars over the course of a few decades.
A gap like this (1.74%) is enormous. Don’t overpay for your investments and be sure their returns track with their peers and benchmarks.
6) Concentration Ratio
What it Measures: The amount of invested assets you have in a single asset.
Equation: Cumulative Value of Largest Investment Asset / Total Invested Assets
Goal Score: Less than 10%
I have a humbling story to share. Well, at first it’s awesome, but then it’s humiliating.
In 2017 bought ROKU stock for around $40 a share.
In 2021 as we were in the throws of the pandemic, the stock almost reached $500 per share. My holdings were well into a 6-figure value at that time.
For some reason, I had selected $500 as my “get out” price and decided to stay put until the stock hit that mark.
The price retreated in mid-2021 but rebounded later in the year. I was confident that it would surpass $500.
But it didn’t.
It just fell and fell and fell.
I vividly remember selling after it dropped below $200/share and I actually held onto some of it even then.
That’s still a five-fold increase, but all I could see was a stock that was less than half as valuable as it had once been.
The problem with owning individual stocks is that we tend to set artificial buy and sell points that we don’t stick to or never reach.
What we should do is set a rebalancing policy that we hold ourselves accountable to no matter what.
Rebalancing is a very wise way to invest because when times are good it forces us to take gains off the table before we lose them. Conversely, when times are bad rebalancing forces us to buy while prices are discounted, ensuring we participate in better future returns.
Most commonly, people rebalance asset allocations from stocks to bonds and vice versa. When stocks are doing great, we sell them in favor of bonds which could be lagging or available at a discount.
On the other hand, when stocks are taking a beating having a rebalancing strategy forces us to do the scary thing and buy when prices are low, making our future returns even more valuable.
You should also do this with individual assets that make up a large portion of your portfolio.
I recommend holding no more than 10% of your total investment portfolio value in a single asset.
Most often, this is going to be a single company stock, but if you invest in real estate it could be a single or group of very similar properties too.
To calculate the concentration ratio, divide the value of the single investment asset you own the most of by your total investment portfolio value.
For example, if you have $30,000 of TSLA and a $150,000 portfolio, you have a concentration ratio of 20%. Time to sell.
You should especially keep an eye on this ratio if you are given or sold stock at a discount by the company you work for. In this case, your income and your assets are connected to one single company.
That’s a lot of eggs in one basket. Consider selling those company stocks or at least limiting the amount you accumulate.
Also, leave your personal residence out of this ratio. It is a use asset, not an investment.
7) Income Diversity Ratio
What it Measures: One’s dependency on a single source of income
Equation: Annual value of largest income source / Total annual household income
Goal Score: Less than 60%
Just like diversification in asset classes provides stability in investing, having multiple sources of income provides stability to cash flow.
I have shared in previous posts that I was unemployed for a brief period in 2015.
Unemployment helped me realize a couple of things.
First, opened my eyes to how little control I really had over my employment.
The thing it helped see was that as long as my income was coming from my job, I was totally dependent upon that job.
Being dependent on something I couldn’t control did not sit well with me.
One of the ways to limit this dependency is to generate multiple income streams, and that is much easier said than done.
I’m not sure about you, but one 40-hour-per-week job is about all I have energy for. The good news is we live in a time and economy that is far more friendly to side hustlers than ever before.
I won’t enter a lengthy discourse about other potential sources of income, but I will challenge you to keep an open mind and think about how your talents might align with a market of some sort. Odds are, there is something out there you can get paid to do in your free time.
Additionally, if you are single you have an automatic headcount disadvantage in your household that makes income diversification all the more challenging.
I’m not suggesting you enter a relationship for the sake of improving your income diversification ratio, but you should at least have a healthy understanding of the extent of your dependence upon any one source of income.
So, even if changing this ratio would be a significant challenge for you, just going through the motions of calculating it is helpful for developing perspective.
Oh, and about calculating your income diversity ratio, simply divide your largest household income source by your total household income.
As an example, if the largest source of income in your household is $75,000 per year, but your household income is $135,000, your income diversity ratio is 55.5% ($75k/$135k).
8) Investment Efficiency Ratio
What it Measures: How tax-efficient your investment approach is.
Equation: Annual amount invested in tax-advantaged accounts / Total amount eligible to contribute to tax-advantaged accounts
Goal Score: Depends on your income. Normally, at least 15% of income
Investment Efficiency Ratio is the percentage of your savings that is directed into a tax-advantaged account like a 401(k), IRA, or HSA relative to the total amount you can contribute to these accounts.
The purpose is to highlight how tax-efficient your investing strategy is. Money saved in these accounts receives tax benefits that are otherwise unavailable, so each dollar saved elsewhere may cost you.
To calculate this ratio, simply divide the amount you contribute to tax-advantaged accounts each year by the total amount you can legally contribute to tax-advantaged accounts.
For example, if you contribute a combined $10,000 annually to an IRA and 401(k) but are eligible to contribute up to $7,000 in the IRA and another $23,000 into the 401(k), your investment efficiency ratio is 33.3% ($10k/$30k).
A “good” target is income-dependent, but you should contribute at least 15%-25% of your income into some combination of these accounts each year. Anything below that should be addressed.
Wrap-Up
Measuring financial progress is important, but it doesn’t always have to be terribly complex. I hope these eight vital signs provide some insight into your own financial strengths and opportunities.
