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If you asked me what part of our approach distinguishes us the most from other wealth managers that we encounter in the market, I would say it is our focus on required return. As Markus likes to say, we don’t just ask whether our clients feel “conservative, moderate, or aggressive” today and use that answer to pick a model portfolio. In our view, picking a specific strategy and products should never be step one. (In our approach to working with clients, it is typically the third.)

Instead, as outlined in one of our most read articles of the year, we focus on what return our clients actually need. We take into account their overall wealth and its categorization into the Aspirational Investor Framework and their Investment Objectives. Subsequently, we try to calculate what level of return the client actually needs to maintain their wealth under consideration of parameters such as the investable wealth, income requirements (whether today and/or in retirement), as well as inflation and taxes. It is that figure that subsequently drives their strategic asset allocation, and eventually, the final implementation.

While I have personally found our approach to be somewhat rare amongst our peers, it is admittedly less unique among our clients. Many of them ask themselves what return they need, and have built their own little models to find that answer - these days, of course, fueled by Claude, Gemini, and the likes. And while no model calculation is ever perfect, we tend to see a few common mistakes across those models.

Today, we want to cover a few common mistakes, and how we would argue they can be fixed. Let’s dive in!

One of the first clients I ever worked with sold their business for a high seven-digit / low eight-digit figure. Despite living expenses slightly in excess of some of the other clients (think low/mid six figures), they felt good about their overall trajectory. But as I took a first closer look, things looked a bit more challenging. Besides underestimating their actual living expenses (more on that in the next section), they made a, well, common mistake: Mistaking their net worth for their investable capital. More precisely, they saw their full eight/nine digit fortune as the “denominator”, i.e. the capital base from which they would generate their income.

But a closer look put that approach in question. There were three categories of assets that we saw which we argued should be excluded from their asset base:

Taking into account those three categories, their actual investable capital from which they’d draw income was essentially cut in half, to ‘just’ 40-50% of their investable wealth. Paired with their above-average living expenses, resulting in a required return somewhat above what could’ve been reliably achieved - requiring more work outside their portfolio to bring their long-term security into calmer waters. (For a bit more context on this story, read more here.)

So if we try to learn from that story, affluent entrepreneurs should be critical in reviewing what parts of their portfolio can actually contribute to their long-term income requirements. Frequent readers know that we solve this with the Aspirational Investor Framework: categorizing which assets belong in the Safety Bucket (i.e. a personal residence) and the Aspirational Bucket (your own company or a venture portfolio), leaving you with a clear understanding of what part of your portfolio can generate stable, liquid income - your Market Bucket. And for assets which you think might contribute to your income in the future (i.e. an earn-out, or a distribution from your venture portfolio), perhaps don’t include them from day one, but make assumptions on when you would expect distributions that you can reinvest into your ‘Market Bucket’, and implement said assumptions in your model.

Most affluent entrepreneurs underestimate how much they actually spend in their day-to-day.

The problems typically begin with the post-exit “lifestyle creep”. When someone sells a business, typically they have a one- to two-year period in which they stay employed with their company, thus still earning a salary. But of course, they also received what is typically multiple million euros to their bank account - which they happily, and deservedly, start spending on whatever their heart desires.

Initially, that’s not a problem. But it becomes one when they eventually leave their company: they no longer have a salary to at least offset their day-to-day spend, and often stay at somewhat elevated levels of spend outside their day-to-day (i.e. nicer vacations, business class rather than economy class, etc.). Overall, leading to an inflated level of ongoing lifestyle expenses that is hard to go back from. I yet have to see a client reduce their spend again - we find it much more likely for them to build another income stream to offset their expenses.

But more importantly, there’s the living expenses - and everything else. Most affluent clients that we ask tell us that their living expenses are somewhere in the range of ~10,000€ per month. But when we dig deeper, there is always a number of other recurring costs, including but not limited to:

Very quickly, 10,000€ can turn into 15,000€, if not 20,000€ a month. Of course, I don’t want to be the person who tells a client to spend less - as mentioned, that rarely works. And more often than not, our clients can also make that higher figure work based on the size of their wealth. But planning for 10K/month when it’s actually 20K/month can result in challenges - not just in your model, but in reality, as well.

So let’s assume you made sure to avoid common mistakes #1 and #2. For the purpose of calculating your target return and/or long-term wealth projection, you are only taking into account the capital that is actually investable at a relevant return, and somewhat predictable liquidity (i.e. 5M€, all at your holding company level). Furthermore, you made sure to get a comprehensive overview of your income requirements, taking into account not only your day-to-day expenses but also other line items such as mortgages or operating costs for your holding company (let’s say 180K€ a year, all at the private level). 

Simple math would tell you that you require a return of 0.18M€/5M€ = 3.6% p.a. to cover any ongoing living expenses, meaning that as long as your return is higher than that, your wealth actually grows despite your ongoing income need. Now we’re good to go, right? You’re likely better off than many investors with simple models out there. But in our view, things are not quite comprehensive yet. (It is also why we are not generally a fan of the commonly mentioned 4% rule - while it works in its initially intended case of retirees with large, liquid portfolios, it is less applicable to younger investors and/or those with more complex structures.)

First, one of life’s unavoidable things - taxes. Unless you live in a jurisdiction without capital gains tax, the aforementioned 3.6% p.a. are actually not enough. Assuming for example that you hold all your assets at the private level in Germany and invest it in a non-equity ETF (taxed at roughly 26.375%), your required pre-tax return actually needs to be higher to achieve your desired post-tax return of 3.6% p.a. To be precise, around 4.9% p.a. (= 3.6% / [100%-26.375%] ).

But of course, things are rarely so straightforward. In the example from the introductory paragraph of this section, the assets are actually not held at the private level, but the company level, meaning they are taxed at a different rate - which in return differs by asset class. Your tax burden might (or might not!) be reduced depending on the taxable expenses at the level of your holding company. And lastly, there’s the question of how to move the money from the company to your private level to be spent there, which could be via distribution, loan, and/or via salary. As you can see, complexity increases quickly - and that’s just for your ‘regular’ affluent German individual with an equally regular holding company, and not a multi-generational, multi-jurisdiction family office.

Do you need to model all of those tax-related complexities in full detail? Likely not. But taxes, especially modeled in a more conservative fashion, are a necessity in any long-term wealth projection. Otherwise, you might underestimate your target return by almost 40% (4.9% p.a. including taxes vs. 3.6% without taxes), or even more if involving a holding company.

(As always, none of this should be construed as tax advice, but rather as illustrative examples. If you want to make sure that your current setup is the best it could be, and/or that your wealth projection properly captures all relevant factors, reach out to our colleague and tax advisor Tamara.)

If you’ve made sure to take taxes into account, your model is likely already on a good track. However, most models at this point are still missing something that we think is crucial: moving from a model capturing a “single moment” to a proper multi-year analysis. Let me explain, using another factor that we haven’t talked about yet: inflation.

Let’s work roughly with those aforementioned figures again. 5M€ but at the private level, 180K€ in annual living expenses. Roughly said, we know that our after-tax return requirement is 3.6% p.a., meaning that we require a pre-tax return of at least 4.9% p.a. As mentioned, this being a conservative observation, as not all of our ongoing share/ETF sales might be fully taxable from Day 1, or because we might invest in ETFs/funds that are taxed at a lower rate. But this is an observation for just a single moment in time: as we’ve already established, there are many factors that actually change over time, such as the level of accrued gains. 

The most important factor to take into account, without a doubt, is inflation. What might be 180K€ in spend today turns into 240K€ in expenses by year 10, and roughly 360K€ by year 23/24. That’s under consideration of a 3% long-term inflation rate, which represents the long-term historical average, but might be too low for long-term ‘luxury’ lifestyle spend according to some of our clients. Continue that calculation over a 50-year period (for some of our clients, we model even longer, to their 100th birthday, which can be a 60-70 year calculation), and the effect becomes immensely meaningful: what started as a simple, “single-observation” 4.9% p.a. return actually becomes a 7.6% (!) multi-period, inflation- and tax-adjusted return in one of our models.

And once again, that is with some more complexity (i.e. the varying degrees of taxable gains required for ongoing income) in the model, but far from all typical complexity that we see at the client level, such as a holding company, multiple asset classes, and so on.

While I generally advocate for less complexity wherever possible, a wealth projection and/or return calculation is one of the few places where I think a certain level of complexity is firmly required. It’s not that I want to convince clients that they need a complex model like the one we have - rather, as hopefully visible from our calculation, adding just a bit more reasonable but required complexity (taxes, inflation), can substantially change the results. If your model doesn’t include some of these meaningful factors, you might underestimate the required return, and at worst might end up running out of money at some point in your life. Something that we don’t just want to avoid for our clients, but of course for you as well, dear reader.

But it’s important to keep one thing in mind: in the end, any model, no matter how simple or complex, remains a model. They are driven by assumptions, some of which we can control, but many of which we can’t - first and foremost, the returns generated by the market. 

And that’s where the title of this section - “all models are wrong, but some are useful” - comes into play. In other words, you shouldn’t take any output for granted, but you should absolutely use it to assess where you stand, and to identify where you can improve. 

Using a more complex model such as our internal one at Cape May, perhaps your target return comes to 7% p.a., somewhat achievable in our view but certainly not risk-free. As mentioned, you can’t influence that 7% target return itself - but you can influence the factors that get it to that magnitude: Maybe you can improve the setup of your investments, reducing costs and/or where they are placed structurally (private/holdco level). Perhaps you can increase your denominator, i.e. your “Market Bucket”, by reinvesting proceeds from your Aspirational Bucket into your income-oriented portfolio. Or you can increase your income, and/or reduce your spend.

And once you make those changes, you can immediately see the ‘theoretical’ impact. Maybe taken together, that gets you from 7% to 6% or even just 5%, considerable differences without having spent a single day on investments yet.

Hence, dear reader, I would encourage you - spend the time to build a model that covers the proper level of complexity, appropriate to your situation, to assess what drives your outcome outside of model returns. Or, of course, reach out to someone like us - we’d be happy to help you with all of those questions.

Not sure whether your current wealth projection is capturing the right level of complexity - or whether your required return is actually achievable? Both are questions that we regularly help our clients answer. We’d be happy to run the numbers with you, outlining actionable ways to help you bring down your required return.