The first day of my (Tim) Introductory Microeconomics class our teacher provided us with a few key tenants surrounding microeconomics; 1) assumptions must and will be made (I still don’t agree with this principle and feel it can distort the real world – maybe it will be our next blog post), and 2) there is no such thing as a free lunch. The second point baffled me at first. I had heard of opportunity cost, but I had never truly sat down and thought of its real-life application. Our teacher began peppering us, attempting to see if we could break this fundamental rule. It is a difficult and an almost impossible task. Anything you do has another side of the story; as humans, we are constantly battling a zero-sum game[1]. Opportunity cost is real and is a core tenant not only in economics, but in your financial plan as well.
When a family or individual approaches us to begin assessing their ability to retire and live on a fixed income, we explain that financial planning comes down to a simple equation: income (I) – expenses (e) = free cash flow (FCF). Where things become subjective and more complicated is the composition of I and more specifically E. A subjective piece to E, is the rate at which it is increasing over time, otherwise known as inflation. One metric used to describe inflation is the Consumer Price Index (CPI)[1], which measures the rate of change for a basket of goods and services purchased by households. CPI is a general indicator of the rate at which E is increasing over time. The issue – not every E category is inflating at the same rate. Furthermore, each E category has a differently weighted percentage relative to E. Meaning, averaging CPI over time and applying that percentage across all E categories may produce results that are not indicative of the future. To produce a more accurate picture, you must understand the amount you will be spending for each E category and then apply an appropriate inflation rate[2]. Moving forward, one E category one must truly understand is healthcare.
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June 2018
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