In the previous blog post, we introduced the Growing Perpetuity model - which we will use to understand how much capital or wealth we need to reach our financial goal.
Now it is time to populate the right side of the equation with our assumptions regarding our desired cash flows, the expected return of our investments and expected inflation.
Estimating now the desired cash flows in 15 years (my time horizon) is extremely difficult - I will get my first newborn in February this year and I have just no clue how to account for that for example.
That said, I can at least rely on 5 years of data categorized in the way I have shown you in the first posts on this blog and that can give a rough indication of my spending patterns.
Based on that I came up with the below:
- Rent (or Mortgage) & Utilities = 1,700 Euro / Month
- Groceries & Restaurants = 370 Euro / Month
- Insurances (e.g. Healthcare) = 130 Euro / Month
- Others (e.g. Holidays) = 450 Euro / Month
In total, this amounts to 2,650 Euro / Month or 31,800 Euro / Year. If I would live into my own house without a mortgage, this would help dramatically reduce the expenditure runrate.
Another very challenging piece of the puzzle to estimate is for sure the expected return of our investments. I cannot understate how much is written on this topic - sometimes with good reasons and more often than not without any. The return is also heavily influenced by the asset class you decide to invest into - stocks provide different returns than bonds - and while our preference is for passive investing, you can find index funds for both asset classes.
As I will show you in a different blog post, I invest in Equity Index Funds and therefore should look into this asset class specifically.
Here you can go really wild in terms of predictions - for example, you could take as reference the fact that the S&P 500 (an American Index that groups the 500 leading publicly traded companies in the USA) compounded annual growth rate (CAGR) is around 11.7% (Nominal) from 1950 until 2021. Or you could look at the broader world economy in the last 10 years and see that an Index Fund replicating that has had a CAGR of 13.3% (Nominal, Vanguard FTSE All-World UCITS ETF Distributing). There are many examples that would yield lower numbers - for example, if you invested in the Nasdaq (another American Index) at the peak of the dot.com bubble (February 2000) until today, you would have had a CAGR of "only" 3.3%.
After reading more on the topic, I will use for my equation 6% return on investment. I am not saying this is right - it is just what I feel comfortable with at the time of writing.
Before we move to the last part of the equation, it is very important to understand that there is NO way the market will give every year a 6% return. We will be exposed to downturns and upturns - and the sequence (whether you have a downturn before and an upturn after or the other way around) matters! Therefore, we will need to "stress" test our assumptions later on. Every model is a simplification of reality and if we dont recognize this, we are doomed to fail.
The expected inflation is the last piece of the puzzle and again it is not an easy prediction to make. In the last 20 years the inflation in the Netherlands has been around 1.85% and in the Eurozone around 1.62%. To be on the conservative side and also considering I reside in the Netherlands I will go for 1.85%.
We have now all pieces we need to calculate the amount of capital required to have in 15 years 2,650 Euro of cash flow every month, adjusted by 1.85% for inflation every year to retain the purchase power. The "big" reveal will be part of the next blog post!
PS so far we are NOT considering taxes! The reason is simple: every country has different tax regulations and what I would do to consider the Dutch regulation is likely to be useless for everyone outside the Netherlands. This is again another simplication - at least for now ;-)
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