When I prepare a financial plan for clients, my report includes a simplified balance sheet, setting out their existing financial situation.
A fairly typical balance sheet might look something like this:
The details will vary, but you get the picture.
For the purpose of making investment decisions and getting a sense of a household's financial trajectory, you often don't need the balance sheet to be more complex than this.
But in a sense, this balance sheet misses something important. Most households have "shadow assets" which I wouldn't normally include on a balance sheet like this. But they are valuable, or have the potential to be valuable.
"Shadow assets"
"Shadow assets" are assets that can't really be liquidated, but have the potential to be valuable in the future. (This is my own terminology. You can use your own.)
If a client has put money in an investment that is very speculative, such as a startup that may or may not take off, I might include the investment on the balance sheet with a nil value, or I might not include it at all. For the purpose of making investment decisions, it's usually best not to consider it as an asset.
The returns from this sort of investment could potentially dwarf the returns they get elsewhere. Or they might be worth... zero. It's usually best not to count eggs until they hatch. (Of course, there are always exceptions to the rule. You need to take everyone's circumstances as they come.)
Some people might even consider anticipated gifts and windfalls from family members as "shadow assets". Most people prefer not to plan on this happening, but I mention this for completeness.
Sometimes people have investments that might potentially have some value, or might actually have some personal, professional value, but you can't really value. Take this blog, for example. It doesn't generate any revenue directly. But it indirectly generates revenue in terms of attracting clients for my financial planning business. At a personal level, I consider it an asset, and with every article I publish I'm investing in the blog. But it would be hard to say it has any tangible value that I can realistically put on my balance sheet. It's a shadow asset.
Most working people have a really valuable asset that isn't on their balance sheet. All else being equal, the younger a person is, the more valuable this asset is. Over time it reduces as this asset generates revenue, and hopefully they transfer a portion of this income into tangible lifestyle and investment assets, after contributing to their day-to-day living expenses.
Tell a 40-year-old that they have an asset that will generate, say, $100,000 in income each year for the next 25 years ($2.5 million, without doing any fancy calculations), and they'd be delighted. It'd be weird if you didn't include this asset on their balance sheet.
This mysterious asset? It's your own ability to generate an income. Each working person is something of an asset, generating a variable income over the course of their working life.
For a household with a fairly young couple, both with decent earning potential, their balance sheet including shadow assets might look something like this:
Some takeaways
- This is a variation of an article I wrote some time ago, where I explained that the younger you are, the wealthier you are. When you start to consider your earning potential as an asset, you realise that when you're young and you have your career ahead of you, you actually have a lot of wealth. This wealth isn't liquid (although in some cases you can borrow against this asset: in a sense, when you take out a mortgage, you're borrowing money against your ability to generate income to repay it back). But it's a form of wealth. The hope is that over time at least some of this income will translate into assets that will provide you with accommodation and assist you with your long-term living expenses when you're no longer working.
- When you start to think of your ability to generate an income as an asset, two things become apparent:
- It's a super valuable asset. You insure other valuable assets, like cars and vehicles, right? Then gee whiz, you should insure your ability to generate an income.
- If the expected present value of your future income is such an enormous fraction of your actual wealth, it makes sense to invest in yourself. Making the right investments in increasing your earning potential can generate enormous returns. It also behooves you to manage career risk.
- If you want to become comfortable, or relatively wealthy, it pays to have the ability to generate a good income. If you want to become really wealthy, you'll often do it via "liquidity events" -- situations where investments that might previously have been best thought of as "shadow investments" suddenly turn into real, tangible cash. Most speculative investments will end up as duds. The but the ones that hit might dwarf everything else.
This isn't something I discuss in a lot of detail with my clients. But for the right person, thinking in terms of shadow assets can be a revelation.
