Most people think of a valuation as something that only applies to assets. For example, your house might have a valuation of £500,000; or your ISA might be worth £200,000. But there are many things that we don’t usually think of as assets that also have a value, though harder to assess. For example, say your salary is £50,000 a year, and you plan to retire in 5 years time. Then a rough valuation of your job might be 5 x £50,000, or £250,000. This ignores factors such as inflation and the possibility of redundancy or death; but you can see that viewed this way your job is an asset.
Utility
The example of valuing a job illustrates the concept of ‘utility‘, which is an term economists use. However utility isn’t the same as valuation. Utility arises from consumption rather than income. But you need money in order to consume. During our working lives, most of us fund consumption from our earnings. Sometimes we increase it by borrowing; this puts a dent (hopefully temporary) in our net worth. After we’ve retired, we fund consumption from any guaranteed pension income, and also out of our accumulated assets; this might take the form of a gradual drawdown, or we might convert a chunk of assets into a lifetime annuity.
But utility also isn’t simply the amount we consume. It also depends upon the personal value we get from it. This can differ from person to person, and from situation to situation. For example, compare the personal value of spending £10. If you were homeless and destitute, you’d derive immense satisfaction from it. But if you were a billionaire you’d hardly notice it. The same amount of consumption has radically different utilities for different people.
In addition, many people can derive utility from knowing they’ll pass wealth on to their heirs, rather than consuming it all. This is a personal attitude that varies widely.
Extending the idea of valuation
Part of the role of a financial adviser is to help us choose investments. Investments form the backbone of our retirement plans. The eventual utility we can expect to get from our assets depends not just on their valuation today. We also need to take into account the likelihood of the valuation going up or down. This depends upon the type of asset, on its growth prospects, and also on its volatility.
For example, if we spend a fixed £20,000 a year from a £100,000 cash deposit, it will last us slightly over 5 years, depending on interest rates. But what if we spend the same fixed £20,000 a year from a portfolio of high-risk shares? Depending on how the shares perform, the portfolio might be exhausted in well under 5 years, or it might last considerably longer; there’s no way of knowing for certain, but we can estimate the probabilities. If the average length of time before the funds run out is more than from cash, that suggests that the shares may provide more utility. But if we’re risk-averse, then the stress of watching wild swings in our portfolio valuation may reduce the utility to us. And if we actually ran out of cash too early, any utility we might have enjoyed up to that point could be wiped out.
So it helps to take into account risk aversion or tolerance when valuing an investment portfolio in terms of its utility.
Holistic valuation
Our finances are much more than just our investments. We’ve already mentioned our earnings. We’ve also mentioned risk-aversion. All of us have other personal goals and attitudes too. And we mustn’t forget other major assets such as our home. There are also some things over which we have little or no control, such as inflation, our health, or how long we’ll live, which can have a significant effect on our finances.
A major contributor to a holistic financial plan is our spending. The more control we’re able to exert over spending, the easier it becomes to manage the risk of running out of money during our lifetimes. If we set ourselves a rigid lifetime spending plan, such as the 4% rule, then if investments badly underperform we may run out of money. Modelling shows that a flexible spending strategy often results in better outcomes than a rigid one. If we’re willing and able to flex our spending as needed, we’re on a much safer course than if we’re rigid.
Another key ingredient of a holistic financial plan is taking all our assets into account. For example, we might tell ourselves we want to fund our retirement spending exclusively out of our pension savings. But what about other savings and investments, such as ISAs? And what about our home? Ignoring these other assets can result in a plan with worse modelled outcomes.
Then there’s tax. The way we organise our assets and withdrawals can help mitigate tax losses. This in turn increases the overall valuation of our financial plan.
There’s no perfect approach. We always need to make some assumptions, some of which may prove inaccurate. But combining spending flexibility, a holistic view of assets and tax‑efficient structuring can make it more likely that our modelled financial plan will be effective.