life, family, the world, wealthbuilding and the pursuit of happiness

Jan 1, 2008

net worth or net worthless?

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Having been involved in several conversations about the calculation of net worth recently, I’ve come to the conclusion that net worth isn’t that important to know. The reason? Net worth is a very difficult number to analyze, and the difficulty in analyzing it makes it a somewhat worthless tool for measuring progress in your financial life.

1. You don’t know how it’s calculated. A lot of people include home equity in that calculation (value of the home less mortgages/loans against it). I don’t include it, because I believe that it’s not a value you can “cash in.” If you cash it in, you still have to buy a new place to live. The only way to “cash it out” is to sell and then move into a rental or downsize, which is not a typical move most people make these days. The counterpoint is that it is an asset that you can borrow against; a bank will give you a loan against that value. Regardless, you just can’t know if people include it or not.

2. A net worth of $200,000 means different things in a small town in Texas and in La Jolla, California. In one place it’s a substantial amount that could generate a sustainable income. In the other place it’s lunch and a tip. Many of us may know that we’re staying put our whole lives, but many of us might be living practically anywhere in 20 years. Knowing whether you’ll be living in Smallville or Gotham would make a big difference.

3. Net worth doesn’t accurately measure cash flow generation. If you have an asset (a rental property, etc.) that generates cash flow, is that worth the same as one that doesn’t (like bricks of gold or a non-dividend paying stock)? In the long run, of course, that cash flow adds to net worth, but the potential future accumulation of cash isn’t really represented in a snapshot view of net worth. That’s not the purpose of a net worth calculation, but it is a problem with analyzing it.

4. Net worth also doesn’t show risk. If I have $500,000 invested in equities, is that the same as $500,000 invested in a money market? Again, for a snapshot in time, yes, but one of them is substantially riskier than the other. If you could apply some sort of risk calculation to your holdings it might make a difference in how you look at the overall picture, as well.

I don’t think it’s all that important to know your net worth. If you use it for motivation or simply feel better knowing what it is, by all means do so. But just like knowing that Harold weighs 200 pounds isn’t that helpful in getting a picture of him unless you also know whether he’s 5 foot 3 inches or 6 foot 8 inches, or whether he’s solid muscle or flabby, knowing your net worth doesn’t tell you everything you need to know about your financial position. It’s part of the picture, but definitely a small part.

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This post was inspired by Moolanomy’s net worth writing project. Here’s what other people who participated are saying about net worth:

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Note: Just because of the busy holiday weekend, guests, etc. I fell behind on my blog reading so I didn’t have many starred for a link roundup. I participated in two carnivals this week, and hopefully I’ll get through those and have a few links from the carnivals and my general reading by Saturday. Also, Emily was the winner of the “mystery CD” and I’ll leave it up to her to disclose what it was when she gets it.

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Viewing 30 Comments

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    I agree that it's all relative. It really shouldn't be a bragging point for sure. But it makes for a great motivator when you are overall in the red! Crossing the threshold into black is like a monkey off of your back. It's a great point though that any number for your net worth needs to be seen in a bigger picture of things.
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    Great post. Very similar to the one I was thinking of writing :)

    When I first became "financially aware", I kept track of net worth because it was a great motivator for me. However at that time my net worth was basically made up of my debts so my "net worth" was really a proxy for my debt. Later on I stopped calculating the net worth because the changes in net worth didn't track my actions ie house value/markets might go up or down which had nothing to do with my contributions or debt payments.

    As you also mentioned, a more relevant calculation is to look at the income you can derive from your investments and compare that to the income you need to live on.

    Mike
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    Steve, I definitely agree that not knowing how it's calculated is a big issue. I count home equity in my net worth, because to me the ability to cash in is not a consideration of net worth. (I have many investments that I know I will never sell, but I count those as well.) If you want to buy a franchise, your home equity may very well not count towards the minimum net worth requirements, specifically because you can't cash it in.

    On the other hand, I don't count "stuff" in my net worth. When I paid cash for my car, my net worth took an instant $14,000 hit. But some people would include cars, furniture, TVs, etc., making for very inconsistent comparisons.

    Maybe I think net worth is a bigger part of the picture than you do, but I agree that it's just part of it.
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    Networth might be more valuable for those of us who have high levels of debt. It gives a more positive picture of our financial situation than just looking at the pile of cash that we owe - possibly false picture - but motivating never the less.
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    Steve, I think this is a great article, and very much in line with my views (although I did use of house in the calculation). I don't often write about net worth, especially my own, because as you mentioned, it is arbitrary. However, I think knowing certain things such as the total value of your retirement holdings, cash flow producing assets, and other sources of money or equities is very important, especially when preparing for retirement. One of the things most people do not include in their net worth is their income from their job or other sources, which is not technically part of your net worth, but is most often the most valuable asset you have.
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    As long as you know how your own net worth is calculated, that's all you need for comparison quarter to quarter, no? I do keep track of it, though somewhat haphazardly, as both a motivator and an occasion to sit down and check all my accounts (I have accounts of one sort or another in four different countries...) to make sure nothing's going wrong in any of them. If I graphed it, it would look insane I'm sure, in the last few years I've sold an aprtment in one city, bought a house in another, done some renovations, imported a car, gone from one to two to one households, and on and on. But I stop short of tracking market price for my house because that does seem a pointless exercise to me, and frankly I just couldn't be bothered. And like Hunter, while I have a relatively detailed home inventory for insurance I don't calculate any personal belongings ... which is always the most curious line item for me in any of the published net worth calculations, some people including $50,000 and some $5,000.
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    One of the things most people do not include in their net worth is their income from their job or other sources, which is not technically part of your net worth, but is most often the most valuable asset you have.

    Patrick - interesting statement.

    A few years ago I almost got laid off from my job and I went through a quick exercise where I looked at my assets (that I could earn income from), debts, costs etc and realized very quickly that my income is indeed my biggest asset.

    This might not be true for someone who is getting close to retirement.

    Mike
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    Stay tuned, Mike. I plan on writing about that for tomorrow's article. ;)
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    I think we all know net worth is just a bragging right. It means little in terms of knowledge of money, means to grow and protect your money, etc.
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    Net worth is never perfect, we can only guessimate
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    Certainly a very interesting and informative post in the least. As I read it I find myself thinking back to one of my fiance's former bosses.

    He essentially generated all of his income with his existing bank account. He bought and ran franchises, more or less. He was the kind of guy really concerned about his net worth and how it reflected onto him as a person.

    He even went so far as living in a ritzy area, Bedford, NH. But his home paled in comparison to all those around him (200k range, when everone else has 800k+)

    In the end of things, no matter how much he was actually worth he couldn't come up with the liquid assets to open up any of the big cash cow franchises, like McDonalds, Dunkin' Donuts, et cetera. Every cent he had was tied and hard to cash out.

    So you certainly make a point, and it's a breath of fresh air to hear someone blogging about net worth like a tool, versus a score in Pacman.
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    I think net worth is about as useful as equity in evaluating a company. I have had some fun lately in evaluation my finances as if I was a company e.g. making an equivalent balance sheet, income statement and cash flow statement. Rather than net worth (which I also hate, when it is used as a bragging point) I think the pertinent numbers are profit margin (which is the equivalent of savings rate), and free cash flow. For home owners, debt to equity is also important. Overall, I think it comes down to what kind of financial lifestyle one leads. For instance, if I had millions, I wouldn't care about income since I could never spend that amount of money anyway, whereas for early retirement purposes, the profit margin is an important measure of financial independence and the free cash flow says something about post retirement capabilities.
    • ^
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    This sounds like the conversation hubby and i had about net worth last week. I think it can be motivating on an individual personal level to increase your net worth but when comparisons start flying, it's just not a very useful tool.

    Great post!
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    I LOVE to calculate my networth. I wouldn't say that it's a valuable tool. However, calculating my net worth at the end of every month makes me re-evaluate my investment decisions (currently only my retirement accounts and mutual fund).

    I agree that net worth isn't a great comparison tool (plus, I'd sounds like a total tool if I said that I was worth $20k at dinner) with others. However, I think it's a great tool at comparing your current situation to your past situation.
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    Too bad "tool" isn't a good google key word . . . :)

    I am going to announce my networth at dinner tonight. I wonder what my 3 year old will think?
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    I just think of all the Jane Austen novels when I think of net worth.

    Net worth = value on marriage market

    :)
    • ^
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    Great comments! I should point out that I don't dismiss net worth's value as a motivational tool. Weight loss is again a good comparison. If I tell you I lost 50 pounds, it makes a big difference if I weighed 250 pounds or 600 pounds as to whether it's an impressive loss.

    I do think net worth is helpful as a motivational tool. I just think that it's overused as a personal finance tool. If you work in finance, you realize that equity is only one measure of a company's health. A million other things indicate growth or stagnation or decline: cash flow, return on equity, profit and loss, earnings before taxes, etc. I personally have tried to shift my thinking to "earning power" - what could I generate in cold hard cash from my assets? That's the true measure of financial freedom.
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    I also lived in a false world for a while basking on my net worth. (with house included).

    I agree that cash flow generation should be a better metric to focus on.

    This is what we should keep making better.

    Now I just have to figure out how.
    • ^
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    I don't calculate networth per se, but I do keep separate running tabs of my debt, my retirement, and my savings accounts. These will give me a good snapshot. Of course, it depends on which day that snapshot is taken!

    Having studied statistics, I find a moving average to be more useful (also a useful tool for weight loss, and goo