Mark Blasini

Articles

The five fundamentals of personal finance

08/25/2023

I've been reading a lot lately on personal finance, trying to simplify and find the key metrics to track. As a result of this research, I've found five key fundamentals that need to be true in order to have stable personal finance. These fundamentals are simple to understand and universal. If you do not have these five fundamentals, you won't have stable personal finance.

Here they are:

  1. Positive Cash Flow (PCF). In other words, income over certain time period (most likely monthly) must be greater than expenses over same time period. This is represented as Income > Expenses (or I > E).
  2. Positive Net Worth (PNW). In other words, all of what you own (total assets) must be greater in value than all of what you owe (total liabilities). This is represented as Total Assets > Total Liabilities (or TA > TL).
  3. Positive Earnings Power (PEP). In other words, the rate of income must grow higher than the rate of inflation. Represented as Growth Rate of Income > Rate of Inflation (or GRI > RI).
  4. Positive Purchasing Power (PPP). In other words, the rate of asset growth must be greater than the rate of inflation. Represented as Growth Rate of Asset Worth > Rate of Inflation (GRAW > RI).
  5. Financial Independence (FI). In other words, the annual return on net worth is greater than the annual expenses. Represented as Annual Return on Net Worth > Annual Expenses (AROA > AE).

Generally, these five fundamentals should work in order. In other words, to stabilize one's personal finance, one should focus first on ensuring positive cash flow, then positive net worth, then positive earnings power, and so on.

Now obviously there are strategies for each fundamental. But the important thing is understanding what you are aiming for. Even more, you can analyze your personal finance issues through the frame of these five fundamentals.

For example, let's say you are living off credit cards - that is, you are spending more than you earn. This is a cash flow issue, which means you have to work on fundamental #1. Or let's say that you earn a good living and are able to cover all your expenses, but you have incredibly high student loan debt, such that you have no cushion for savings or investments. This is an issue with positive net worth.

Or let's say you have a stable income, it covers your expenses, and you have savings, but you haven't gotten a raise in 3 years. This means your income is stagnant and not keeping pace with inflation; every year your expenses rise and this is cutting into the amount of money you can save or invest. This is an issue with earnings power.

Or let's say you earn a great income, your expenses are covered, you have no real debt, but you have all your money parked in a savings account that earns 1% interest while inflation grows at 2-3%. Thus, inflation is eroding the value of your savings. This is an issue with purchasing power.

Lastly, let's say you would like to retire from working, which means your income from your job will no longer cover your expenses. You want to rely on your net worth (total asset value - total liability value) to cover your expenses. However, a recession has just hit and the value of your net worth has gone down. This is an issue with financial independence.

Virtually every personal finance issue can be framed in terms of one or more of these five fundamentals. Get these five fundamentals right, keep your focus on them, and you'll have a stable personal finance moving forward.