The desire that our children learn how to be good with money is a universal

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1 BUSINESS & INVESTING YOUR PERSONAL BALANCE SHEET: A VIEW INTO THE FUTURE By G. Scott Clemons, CFA BBH Chief Investment Strategist The desire that our children learn how to be good with money is a universal refrain, regardless of how many zeros there are at the end of our bank statements. We all know a few cautionary tales of younger generations who aren t good with money, to the detriment of their financial and personal well-being. Wealth is power, and power without responsibility is easily abused. Many careful financial plans fail to preserve and transition wealth when subsequent generations aren t capable of handling the responsibility. Yet what does it mean to be good with money? The phrase is used far more often than it is understood. As with so many vague notions, we tend to know it when we see it, and see it perhaps most clearly when it is lacking. Being good with money is a broad concept that extends beyond knowing how to save and invest. A healthy relationship with money requires us to know how to get it, keep it, grow it, save it, spend it and give it away. It is ultimately an exercise in balance. Money is a means to an end. An effective way to ensure that younger generations understand the proper balance and use of wealth is through the framework of a personal balance sheet. This is a common concept in the corporate world, and the notion is applicable at the family and individual level as well. Just as companies have assets and liabilities, so, too, do people, although a personal balance sheet includes assets and liabilities that are rather intangible. An asset is a store of wealth or anything that will create wealth in the future. The single most valuable asset on the balance sheet of most young people is their own human capital the theoretical present value of a career s worth of income. The primary objective of saving and investing is to make sure that human capital successfully transitions to financial capital by the point at which retirement (and the subsequent loss of income) takes place. Along the way, saving and investing can support other objectives as well, such as a down payment on a first home, advanced education, starting a business, raising kids and philanthropy. 1 Women & Wealth Magazine

2 [T]he balance sheet approach helps young investors to think robustly about asset allocation and how it should change over the course of a lifetime. Fall

3 BUSINESS & INVESTING Although we don t naturally think of these spending objectives as liabilities, in a metaphorical sense they are. Just as an asset is anything that can generate wealth in the future, a liability (even if aspirational) is anything that may one day lay claim to that wealth. Even philanthropy falls into the liability category when we adopt this broader definition. The personal balance sheet of a recent college graduate might look something like the below table. As the example illustrates, future assets and liabilities are often vague. The point of the exercise is not to determine the value of these assets and liabilities to the penny, but to pose the constant reminder that wealth is a means to an end, where those ends are called liabilities for the sake of this framework. This concept also reinforces the value of delayed gratification. This is often the earliest of financial lessons, as young children save a meager allowance in the anticipation of buying a coveted toy. The balance sheet concept extends that lesson across a lifetime of saving and investing, making explicit the transition of human into financial capital over time. What s On Your Personal Balance Sheet? Importantly, the balance sheet approach helps young investors to think robustly about asset allocation and how it should change over the course of a lifetime. If the ultimate goal is to balance assets and liabilities both now and into the future, then asset allocation naturally follows from liability allocation, not from expectations regarding financial market returns, volatility and correlations. As liabilities change (retirement, kids graduation, paying off a mortgage, etc.), asset allocation will likely change, too. In theory, an investor s strategic allocation shouldn t change unless her liabilities do. That s not to say that asset allocation should be set and then ignored. To the contrary, robust asset allocation requires a continual assessment of shifts in spending, consumption, philanthropic interests and lifestyle needs of the investor rather than to anticipated changes in capital markets. This approach also poses a novel definition of risk. Risk is traditionally understood as deviation from a benchmark, such as the S&P 500 index, or the possibility that a manager underperforms a passive index. Yet those definitions don t reflect the ultimate objective of balancing assets and liabilities. The balance sheet approach reminds us that real risk is that the balance sheet doesn t balance: that liabilities are greater than expected, or that assets aren t. Understanding those risks leads to a further refinement of asset allocation, in which risks to the liability side of the balance sheet help to inform how the asset side is structured. As an example, consider the risks that might threaten each side of a personal balance sheet. The spectrum of potential risk is as broad as our definitions of assets and liabilities. For example, if human capital is a significant asset on the personal balance sheet of young investors, then anything which might impair that value (unemployment or disability) is a risk. Some of these balance sheet risks can and should be hedged through insurance: health and life insurance protects human capital, while home insurance protects housing assets. Yet not all balance sheet risks can be hedged through insurance, and this is where the allocation of financial assets enters the discussion. It is important to consider the role that each asset class plays in addressing the risks to one s balance sheet. If liabilities such as tuition or mortgage payments have certain due dates, then something on the other side of the balance sheet should hedge against that liquidity risk by being in a liquid asset class. Fixed income assets usually play this liquidity role in a portfolio. Investment losses or fraud can be managed through effective manager selection and transparency. Personal Balance Sheet of Recent College Graduate Assets Liabilities Cash 10,000 Mortgage 175, k 20,000 Credit Card Debt 5,000 IRA 5,000 Student Loan 20,000 Investment Account 20,000 House/Apartment 200,000 Miscellaneous 10,000 Present Value of Career Earnings Millions Future Liabilities Lifestyle Boat Taxes College tuition Second home Healthcare Philanthropy Toys Vacations New car Et cetera 3 Women & Wealth Magazine

4 Risks to Your Personal Balance Sheet Assets aren t as great as anticipated unemployment disability death taxes investment losses market volatility illiquidity fraud inflation Tax planning is essential to preserving assets and ensuring that liquidity is available once payments come due. None of this is a guarantee. Risk management is an exercise in identifying and mitigating risk, not a means of making it disappear. Note that inflation appears in the nearby table as a risk to assets as well as liabilities. Inflation threatens to erode the real purchasing power of a dollar of assets while increasing the cost of future spending. Although it may seem counterintuitive to consider inflation a risk when there is so little of it at present, modest inflation can wreak havoc to a portfolio across the lifetime of a younger investor. Inflation of 2% dilutes the purchasing power of a dollar by 40% over the course of 25 years. Liabilities or expenses are greater than anticipated healthcare expenses fire flood accident taxes rising tuitions overspending inflation to adjust when they collide with the reality of lifestyle or health change, shifting consumption preferences or inflation, but that is precisely what makes a consistent and repeatable approach to investing and asset allocation so important. General Dwight Eisenhower, a man with planning experience as Supreme Commander of the Allied Forces in Europe during World War II, once noted that In preparing for battle, I have always found that plans are useless, but planning is indispensable. In other words, plans themselves are best understood as periodic expressions of an ongoing process. As a planning and educational tool, the balance sheet approach to investing and allocation has much to offer. It makes explicit the idea that wealth is a means to an end, whether these ends are quantifiable or subjective. It encourages a robust approach to asset allocation that takes into account individual risk profiles as opposed to anticipated market moves. Finally, it encompasses the various uses of wealth saving, investing, spending and philanthropy that, in proper balance, make us and our children good with money. The necessity of protecting portfolios from this threat is why younger investors should typically hold a larger allocation to equities. First of all, liquidity is usually less pressing in the earlier years of a working career, so an equity allocation has time to benefit from compounding returns. Second, equities have historically provided a better hedge against inflation over time, and younger investors face the threat of inflation over more years than older investors. The right allocations will differ from investor to investor, and will differ over time as liabilities and risks change. The balance sheet approach provides a robust framework for understanding both the why and the how of asset allocation and portfolio construction. This approach to investing is, by virtue of its subjective and qualitative nature, necessarily more of an art than a science. No one knows with precision what his or her spending or liquidity needs will be decades down the road, or the degree to which inflation will have increased the cost of meeting those needs. The best-laid plans have Planning for retirement in your 20s? Smart move. Planning for Retirement in Your 20s? Smart Move. The latest video from the CW&W will help young investors understand their options. Visit bbh.com to watch the video. Fall

5 BBH Center for Women and Wealth NEW YORK BEIJING BOSTON CHARLOTTE CHICAGO DENVER DUBLIN GRAND CAYMAN HONG KONG JERSEY CITY KRAKÓW LONDON LUXEMBOURG NASHVILLE PHILADELPHIA TOKYO WILMINGTON ZÜRICH This publication is provided by Brown Brothers Harriman & Co. and its subsidiaries ( BBH ) to recipients, who are classified as Professional Clients or Eligible Counterparties if in the European Economic Area ( EEA ), solely for informational purposes. This does not constitute legal, tax or investment advice and is not intended as an offer to sell or a solicitation to buy securities or investment products. Any reference to tax matters is not intended to be used, and may not be used, for purposes of avoiding penalties under the U.S. Internal Revenue Code or for promotion, marketing or recommendation to third parties. This information has been obtained from sources believed to be reliable that are available upon request. This material does not comprise an offer of services. Any opinions expressed are subject to change without notice. Unauthorized use or distribution without the prior written permission of BBH is prohibited. This publication is approved for distribution in member states of the EEA by Brown Brothers Harriman Investor Services Limited, authorized and regulated by the Financial Conduct Authority (FCA). BBH is a service mark of Brown Brothers Harriman & Co., registered in the United States and other countries. Brown Brothers Harriman & Co All rights reserved PB Expires 3/31/2020