Beyond Net Worth: Future Cash Flows

Why Your Net Worth Isn't the Whole Picture

Ever felt like you're playing a game of whack-a-mole with your investments? You hit one goal, but another pops up somewhere else. That's because focusing solely on net worth might not capture the full picture of your financial health. Jarrod Wilcox from the London Quant Group sheds light on this in his 2009 seminar.

Introducing the Extended Balance Sheet

Wilcox introduces a concept called the extended balance sheet, which goes beyond just assets and liabilities to include future cash flows. Imagine having a crystal ball that tells you how much your business might sell for, or what your inheritance could be worth—those are implied assets. On the liability side, consider future taxes on capital gains or planned withdrawals after retirement.

Leverage: The Unseen Force

Now, why should we care about these future cash flows? Because they affect your discretionary wealth—the funds you have left over after meeting all financial obligations. Wilcox calls this implied leverage. A 10% loss in investments can translate into a 25% hit to your discretionary wealth if your implied leverage is 2.5.

Putting This Into Action: GS, MS, C, and IEF

Let's apply this to real-world scenarios. Say you're managing funds for General Electric (GE), Microsoft (MSFT), Citigroup (C), and iShares 20+ Year Treasury Bond ETF (IEF). You'd consider their future cash flows, like planned dividends or potential mergers & acquisitions, as implied assets. Liabilities might include expected debt repayments or regulatory fines.

Managing Risk in a New Light

Wilcox also challenges traditional risk management. He argues that managing a risky growth rate involves more than just variance. It's about balancing expected return and risk while considering your discretionary wealth—your implied leverage. For instance, a riskier fund like GE might have an expected after-tax return of 6%, but with higher volatility (2.25%). Balancing this against safer assets like IEF becomes crucial.

Bayesian Logic: A Smarter Approach

Wilcox advocates for Bayesian logic in portfolio management. Instead of relying on point estimates for returns and correlations, we should use probability distributions. This helps capture the uncertainty and materially changes our calculations.

So, What's Next?

Start by understanding your extended balance sheet—list those future cash flows as implied assets or liabilities. Then recalculate your discretionary wealth to see how much risk you're truly taking on. Remember, managing risk is about more than just variance; it's about balancing expected return and risk considering your discretionary wealth.